Investment is total investment expenditure by firms on buildings, machinery and the change in inventories. A firm invests in capital goods (machinery and buildings) and uses these capital goods to produce consumer goods. A firm invests to increase its productive capacity so that it can produce more in the future to make more profit.
An increase (decrease) in investment will increase (decrease) AD and shift AD right (left).4
Many factors could increase investment:
1) Profit.
A rise in profits gives firms more funds for investment so investment rises. Also, profits are a cheaper source of funding investment than borrowing so investment becomes cheaper and investment rises. Furthermore, a rise in profits may signal to firms that the return on investment is higher, incentivizing firms to increase their productive capacity to be able to produce more to capture the higher profits.
2) Expectations.
Keynes posits that investment mainly depends on expectations which are driven by ‘animal spirits’ and prone to volatility because they depend on an unquantifiable uncertain future. As expectations rise, firms become more optimistic and expect higher returns on investment, so investment rises.
3) Uncertainty.
Uncertainty makes it difficult for firms to plan and invest. A more stable economic climate means firms can plan how much they will sell so they can plan how much they must invest, so investment rises.
4) Interest Rate.
A fall in the interest rate means the cost of borrowing falls, firms take out more loans and investment rises. Also, a fall in the interest rate makes more investment projects give a higher return than saving so investment rises.
5) AD.
As AD keeps rising in a boom, this signals to firms that profits are rising and incentivizes firms to increase investment to increase their productive capacity to produce more to capture these higher profits, so investment rises.
6) Income.
An increase in income means consumption rises, so firms may need to invest to increase their productive capacity so that they can produce more, so investment rises.
7) Cost of Capital Goods.
As the cost of capital goods falls, the cost of investment falls, investment becomes more profitable, so investment rises.