Real investment means the addition to the stock of physical goods.

New expenditure incurred on addition of capital goods such as machine, buildings, equipmens etc. This addition raises the aggregate demand and brings about further addition to the level of income and employment in the economy.

Autonomous Investment Induced Investment Autonomous Investment : Business investment expenditures that do not depend on income or production (especially national income or even gross domestic product). That is, changes in income do not generate changes in investment. Autonomous investment is best thought of as investment that the business sector undertakes regardless of the state of the economy. Undertaken for the economic growth of the country.

The alternative to autonomous investment is induced investment, which does depend on income. Investment effected by a growing national economy that stimulates demand. As output levels rise, capacity utilization increases resulting in additional capital investment.

Inducement to invest depends upon two factors (i) Marginal efficiency of capital and (ii) Rate of interest. (i)Marginal efficiency of capital The marginal efficiency of capital (MEC) is the higher rate of return over cost expected from the employment of a marginal or additional unit of capital asset. MEC means the expected rate of profitability of a brand new machine. The MEC depends on two factors. (i) Prospective yield "from the capital assets, and (ii) the supply price of the capital asset. The MEC is the ratio of there two factors.

The MEI curve represents the responsiveness of investments(or capital goods) to a change in interest rates. Interest rates represent the cost of borrowing. Theoretically, the lower the rate of interest, the cheaper it is for firms to finance investment, and the more profitable the investment will be. Hence, the level of investment will rise.

A fall in interest rates should decrease the cost of investment relative to the potential yield and as result planned capital investment projects on the margin may become worthwhile. A firm will only invest if the discounted yield exceeds the cost of the project. The inverse relationship between investment and the rate of interest can be shown in a diagram . The relationship between the two variables is represented by the marginal efficiency of capital investment (MEC) curve. A fall in the rate of interest from R1 to R2 causes an expansion of planned investment.

Keynes, however, suggested that investment is in fact relatively unresponsive to changes in interest rates, particularly at the extreme ends of the Trade Cycle. During a recession, businessmen are generally pessimistic about the future outlook and there is also likely to be excessive unused productive capacity, which prevents a fall in interest rates from stimulating I. On the other hand, during a boom, their optimism may cause them to disregard high interest rates. Hence, MEI is more likely to look like the relatively inelastic MEI1 than the relatively elastic MEI2.

Keynes instead emphasized the importance of expectations (entrepreneurship mood), which is affected by the state of the market for their product (which is in turn determined by factors like political stability, cost of production, conducive business climate etc). The expected rate of returns from investment is measured by Marginal Efficiency of Capital (MEC).

The prospective yield means the total net returns which an entrepreneur expects to obtain from selling the output of the capital asset over its life time. Running expenses are deducted from there returns. If the total expected life of a capital asset is divided into a series of years, the annual returns represented by R1 R2, R3 R4, are added. The investor also takes into account the supply price of the asset which is the cost price of a new capital good. Supply price is also known as replacement cost.

In other words the MEC is the rate at which the prospective yield is to be discounted if it is to equal the supply price of the asset. Given the supply price, the marginal efficiency of capital is influenced by future expectations. J.M. Keynes defines marginal efficiency of capital as The rate of discount which makes the present value of the prospective yield from the capital asset equal to its supply price.

A businessman while investment in a new capital asset, examines the expected rate of net return (profit) on it during its lifetime against the supply price of capital asset (cost of capital asset) if the expected rate of profit is greater than the replacement cost of the asset, the businessman will invest the money in the project.

Formula:The following formula is used to know the present value of series of expected income throughout the life span of the capital assets. Sp = (R1/1+r) + (R2/1+r2) + ............ = (Rn/1+rn) Here: Sp = Stands for supply price of the new capital asset. R1 + R2 - Rn = Stands for returns received on yearly basis. r = It is the rate of discount applied each the years.

Schedule: According to J.M. Keynes, the behavior of investment in respect of new investment depends upon the various stock of capital available in the economy at a particular period of time. As the stock of capital increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC curve is negatively sloped as a shown in the figure ahead.

Investment ($ in billion) 20 25 40 70 100

Marginal Efficiency of Capital 10% 9% 7% 5% 2%

In the above table, it is shown when stock of capital is equal to $20 billion, the marginal efficiency of capital is 10% while at a capital stock of $100 billion, it declines to 2%. This investment demand schedule when depicted graphically in the figure gives us the investment demand curve which goes on sloping downward from left to right.

The MEC and the rate of interest are the two important factors which affect the volume of new investment in a country. An investor while making a new investment, weighs the MEC of new investment against the prevailing rate of interest. As long as the MEC is higher than the rate of interest, the investment will be made till the MEC and the rate of interest are equalized. For example, if the rate of interest 7%, the induced investment will continue to be made till the MEC and the rate of interest are equalized. At 7% rate of interest, the new investment will be $40 billion. In case, the rate of interest comes down to 2%, the new investment in capital assets will be $100 billion.

Planned investment can change at each rate of interest. For example a rise in the expected rates of return on investment projects would cause an outward shift in the marginal efficiency of capital curve. This is shown by a shift from MEC1 to MEC2 in the diagram below. Conversely a fall in business confidence (perhaps because of fears of a recession) would cause a fall in expected rates of return on capital investment projects. The MEC curve shifts to the left (MEC3) and causes a fall in planned investment at each rate of interest.

Graph

Hence, it can be seen above that a rise in interest rates may not dampen investment if, at the same time, MEC has increased

The low rate of interest induces investment and high rate of interest discourages it. Rate of interest, in term, is determined by the quantity of money and the liquidity preference. Given the quantity of - money the rate of interest mainly depends, on the strength of liquidity preference of two determinants MEC is the most important one to determine investment.

Summing up, if investment is to be increased in the country, either the rate of interest should go down or MEC should increase.