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Investment is the amount of income not spent on current consumption, but on capital goods that are later used to produce further goods. Keynes contradicted the classical theory of interest that said that savings and investment are independent and determined by the interest rate as it assumed that the savings did not depend on aggregate income(Y). This can only be true for an economy in full employment, otherwise the extended investment brought about by increased savings would ncrease Y and thus shift the svings even further.
Keynes took the accountants view. He said that as investment rises it will be less profitable, because of two reasons. First the product you are investing in has a downward sloping demand curve, as more is produced price must be lowered in order to sell it and thus marginal revenue of producing last units decreases. This factor will affect investment decisions in the long run more often.
Another reasons is that the price of capital is bid up when more investment occurs and thus it becomes more expensive to invest. This will affect businesses more in the short-run.
We can estimate the returns of the investment by defaulting the profit the machine produces over its lifetime and defaulting the value (accounting for inflation) to present total return. Investment is clearly profitable if the value we get is higher than the purchase price. Also as this shows profits the previous two paragraphs showed how the profits could decrease - either the costs can increase or the revenue decrease. It is however more convenient to express this profit the machine produces as a percentage of the total value of the machine. Clearly if more and more investment is done the profits will increase less rapidly and thus the peprcentage of profits will diminish. Keynes called this phenomenon the marginal efficiency of capital (MEC) and it can be expressed graphically:
Keynes did do a small mistake here. Capital usually denotes the whole capital stock, whereas Keynes here is talking about the flow of capital, that is called investment, so the graph should be a marginal efficiency of investment graph.
Now the capital invested could have other uses. The safest of all is to put it to a bank to bear interest. If the real rate of interest (nominal minus inflation) is above ther ate obtainable from the investment, clearly no-one would like to invest (although it would still yield an income). Conversely if the interest rate is below rate of return, firms will invest. This will make investment expensiver and MEC will fall, equilibrium investment I1 being where the current real interest rate (r1)is equal to the MEC:
Clearly if the interest rate would fall the investment would rise and vice-versa.
Now the return on assets is a hihgly subjective value. One can't say it for sure. If the inflation rises the sales will go up and revenue will increase, whereas if costs rise or the demand for goods falls the rate of return would fall. Thus MEC depends highly on business expectations of the economy in the next time period, and of their animal spirits of taking risks and is thus highly volatile. Thus we can say interest rates affect investment, but their effect is not very significant compared to the one of expectations. This also explains how booms form. When business confidence rises rapidly they will expect a great return and invest, whereas when it once becomes apparent that such returns can not be made, then investment will stop suddenly causing the demand for capital to fall and a decline in the overall economic activity.
The expectations are based on the variables that are known to change in the future. These form a minority, but the things affecting the business most in the future can not be determined and although they are bound to change the least error is mode if business will asume them to remain constant. Thus investment decisions are based on relatively unimportant factors. Furthermore a change in such a factor can cause overmagnified and unreasonable change in the investment.
Interest on the other hand is determined in a Keynesian system by purely monetary factors. Demand for money is considered to be interest elastic as people demand money for speculative purpouses as well as precautionary and transactionary. So there is an asset demand for money. If people will expect the price of bonds to rise (i.e. the interest on fixed rate bonds to fall or profits of the company to rise) then they will demand less money and buy bonds. In order to compensate for the holding of money interest rates would have to increase. Whereas if interest rates are falling the penalties for holding moeny are decreased and more money is demanded. Money supply is determined by the authorities and is thus perfectly inelastic:
Now if authorities increase the moeny supply the rate of interest will fall (although in some cases, called liquidity traps, by not very much when Md is very elastic) and this will stimulate extra investment. On the other hand if people expect the interest to rise they will increase their demand for money (speculate with bonds, sell them) and Md will increase, this will cause the rate to increase automatically and investment to decrease.
So the classical price systmem of of equating investment and savings does not apply in Keynesian system. There is a price for investing - the opportunity cost of interest rate, but the link between savings and investment does not depend directly on the price (interest rate), but indirectly through national income. However if the national income rises the demand for money will rise that will raise the interest rates, so the effect on increased investment will be indeterminable, but crtainly not as big as the theory would predict.
Keynes makes a major revision in here. Before it was said that the savings will depend on interest rate, Keynes is now saying that only the composition of savings in dependent on interest rates - interest is the reward for not hoarding the savings, but investing them. A much more complicated ISLM system needs to be incorporated before we can determine the exact effects on interest for the level of investment. This, however, was founded after Keynes by Hicks and thus not relevant. Business confidence as such can not be accurately measured, there is also an involuntary investment to stocks existing when the level of aggregate demand is not sufficient to cover for the output, so according to Keynes the actual aggregate investment can be found by just determining the GDP and sthe proportion of it in savings, actual investment is equalt to that. But the planned investment for the next time period is almost impossible to determine, so monetary policy should not be used to manipulate it, if government requires the investment to increase to reach a full employment GDP level it should do it by its-self, by running a budget deficit.
The model allows for the amount of capital to vary. Thus although predictions are made in the short run, investment is determined in the long-run basis.