Economic Principles Ch17. Investment Function Theory: Choices for the Future

Chapter 17. Investment Function Theory: Choices for the Future

Although investment is smaller than consumption, it is the most volatile and central factor behind business-cycle fluctuations. This chapter closely examines the economic determinants of investment: how firms decide to expand equipment and build factories.

1. Traditional Theories of Investment Decisions

(1) Net Present Value (NPV)

Future returns are discounted to present value and compared with the cost of investment.

(2) Marginal Efficiency of Investment (MEI)

Investment is undertaken when the marginal efficiency of investment ( $r$ ) exceeds the market interest rate ( $i$ ).
Keynes’s view: Investment is driven not only by interest rates but also strongly by entrepreneurs’ “animal spirits.”

2. The Accelerator Principle

This principle states that a change in demand for consumer goods produces a larger change in demand for capital goods (investment).

Principle: Investment is determined in proportion to the increase in output.
Limitation: It does not operate when capacity utilization is low and tends to exaggerate reality; the flexible accelerator model addresses this limitation.

3. Tobin’s q Theory

This modern theory uses information from financial markets, especially stock markets, as an indicator for investment.

$q > 1$ : The stock-market value exceeds the firm’s physical value $\rightarrow$ expand investment.
$q < 1$ : Buying a firm is cheaper than investing in it $\rightarrow$ reduce investment.
Implication: This provides a theoretical basis for stock-price indices to serve as leading indicators of the real economy.

4. User Cost of Capital

This neoclassical investment theory compares the cost of maintaining one unit of capital with its marginal productivity.

User cost: interest cost + depreciation − the rate of increase in asset prices.
Optimal investment: determined where the marginal product of capital (MPK) equals the user cost.

5. Conclusion: Investment Is Tomorrow’s Growth Engine

In the short run, investment causes fluctuations in aggregate demand; in the long run, it expands productive capacity and becomes a foundation for growth. Investment’s sensitivity to interest rates makes it the most important channel through which monetary policy reaches the real economy.

📖 References

[Macroeconomics] - Jeong Byeong-ryeol: Mathematical derivation of investment theory.
[Corporate Investment Theory] - James Tobin: The formulation of q theory.

Well done. Next, we will study an in-depth analysis of the IS-LM model and policy effectiveness, which emerges from the behavior of households and firms.