Investment

In macroeconomics, investment means adding to the stock of capital: business fixed investment (machines, factories), residential investment (new houses) and inventory investment (additions to stocks of goods). Buying shares is not investment in this sense; it only changes who owns existing capital.

Firms hold inventories to meet demand, to smooth production and because some are unavoidable in the production process. Ordering in large, infrequent batches is usually cheaper than ordering small amounts often, which is why CUET 2025 made the opposite claim its odd one out. Housing investment depends on the real return from owning a home; high nominal interest rates with high inflation discourage it, and demand for housing is sensitive to the interest rate (CUET 2025).

Investment depends on expectations about an uncertain future. Keynes called the waves of optimism and pessimism behind it animal spirits, and saw them as the source of instability in income (Hyderabad 2014, 2017, 2018).

A machine costs K today and brings returns R₁, R₂, … in future years. Money later is worth less than money now, because money now could earn interest. At interest rate i, ₹1 in t years is worth 1/(1 + i)^t today. The present value of the returns is their sum after discounting.

A firm invests while the MEC exceeds the interest rate and stops where they are equal (Hyderabad 2011; JNU 2020). Equivalently, invest when the present value exceeds the cost. Because the most profitable projects are done first, the MEC falls as more is invested: that downward slope is the investment demand curve, and a lower interest rate moves the firm along it.

Anything that raises expected returns shifts the whole schedule out, raising investment and aggregate demand at every interest rate (Hyderabad 2011; DSE 2012). Pessimism, say after a shock to export demand, shifts it in (Hyderabad 2021). If investors become less sure of the future, they discount more heavily and expect less: both push the MEC down (Hyderabad 2011).

Dale Jorgenson’s neoclassical theory asks what it costs to use a unit of capital for a year. Two things: the interest you could have earned on the money tied up in it, and the wear and tear. So the user cost (or rental cost) of capital is the real interest rate plus the depreciation rate (CUET 2022).

So a higher real interest rate raises the user cost, lowers the desired capital stock and cuts investment (Hyderabad 2021; UGC NET 2024). A faster depreciation rate does the same (DSE 2009). JNU 2016 accepted both “interest plus depreciation” and “interest plus depreciation minus expected inflation”: the second is the same thing with the nominal rate made real.

Tobin’s q links investment to the stock market (GATE 2026). A rise in share prices raises q, and so raises investment (JNU 2016). Firms find it profitable to invest when q exceeds one (DSE 2016; Hyderabad 2021).

Suppose firms need v rupees of capital to produce each rupee of output a year. To produce more, they must first add capital. So net investment depends on the change in output, not its level (CUET 2018, 2019):

Because v is usually above one, a small rise in demand for consumer goods causes a proportionately larger rise in investment (Hyderabad 2013). And in the linear accelerator nothing depends on expectations: investment is a mechanical response to output growth.

Keep the two ideas apart, as JNU 2015 did: the multiplier takes a change in investment to a change in output; the accelerator takes a change in output to a change in investment. If investment also rises with the level of income, with marginal propensity to invest MPI, the multiplier becomes Hicks’s super multiplier, 1/(1 − MPC − MPI) (UGC NET 2026).

Paul Samuelson (1939) put the two together. Government spending rises once and for all. The multiplier raises income, the rise in income raises consumption, the rise in consumption induces investment, which raises income further, until growth slows, investment falls back and income falls. Depending on c and v, the path settles smoothly, cycles and settles, cycles ever wider, or takes off.

That a model this simple generates business cycles from a single shock is why it is still taught. The Delhi School goes one step further and asks what happens when investment depends on expected output, formed statically (last period’s value) or rationally (using all available information). Those questions are in Lesson 9.

CUET 2023 matched the first four.