Question #50099

What do you understand by investment function?Explain the factors that influence the level of investment in the economy.

Expert's answer

The investment function is a summary of the variables that influence the levels of aggregate investments. It can be formalized as follows:

I=f(r,ΔY,q)

where r is the real interest rate, Y the GDP and q is Tobin's q.

The reason for investment being inversely related to the interest rate is simply because the interest rate is a measure of the opportunity cost of those resources. If the resources instead of financing the investment could be invested in financial assets, there is an opportunity cost of (1+r), where r is the interest rate. This implies higher investment spending with a lower interest rate. When GDP increases, the output and the capacity utilization increases. This results in an increase of capital investment.

I=f(r,ΔY,q)

where r is the real interest rate, Y the GDP and q is Tobin's q.

The reason for investment being inversely related to the interest rate is simply because the interest rate is a measure of the opportunity cost of those resources. If the resources instead of financing the investment could be invested in financial assets, there is an opportunity cost of (1+r), where r is the interest rate. This implies higher investment spending with a lower interest rate. When GDP increases, the output and the capacity utilization increases. This results in an increase of capital investment.

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