Investment demand: factors and economic implications

Investment Demand

Businesses experience profit cycles implying that market fluctuations are inevitable in an economy. Market demand plays a crucial role in the profitability of an enterprise and consequently affects the investment trend. A profitable firm is more likely to invest money to improve production facilities or to extend its business into other domains. Investors will analyze the profitability of any undertaking and only if the expected revenue is greater than the cost of capital will they invest in the project. Keynesian theory also states that the Marginal efficiency of Capital is inversely related to investment. "[t]o induce new investment 'the rate of return over cost must exceed the rate of interest'. [Richard C.B. Johnsson] For all businesses profit is the ultimate motivation and any new venture is undertaken only if the internal rate of return is above the cost of capital defined by the prevailing rate of interest. Hence we see that the capital spending intention is directly related to profitability of an enterprise.

Similarly interest rates of a nation have a direct bearing on the investment pattern of firms. Again it is the cyclical nature of the business which explains this. It's well-known that a considerable amount of household expenditure is based on borrowing. So if the interest rate is lowered it encourages more spending (more borrowing) by the consumers. In the same vein business are also dependent on borrowing funds for their capital investment and other infrastructural improvements. Interest rate is nothing but the cost of borrowing and since a low interest rate means a low cost of capital it would propel more borrowing and investment by firms within the nation.