Thoughts On Investment, IS-LM & Effective Demand

Investment is an essential component of economic growth. Investment supports a healthy inflation rate by providing new money into the economy. What determines investment? Through the IS-LM model, we can understand interest rates and investment.

The IS curve has its own model before it is incorporated into the IS-LM model. In that IS model, investment is a function of GDP (Y) and the interest rate (i).

I = I(Y, i)

“That means that loanable funds doesn’t determine the interest rate per se; it determines a set of possible combinations of the interest rate and GDP, with lower rates corresponding to higher GDP. And that’s the IS curve.” (Krugman)

Do lower rates always correspond to higher investment? No… We still have low interest rates and investment is normal. (FRED data) But what will happen if firms really believe that the Fed will raise interest rates next year? There will be incentive to invest before rates rise. Thus, we obtain higher investment from projected increases in interest rates, more so than the same projected low interest rates.

Investment is a Function of Effective Demand

I add another factor that determines investment along with output and interest rates. I would say that investment is also a function of effective demand.

I = I(Y, i, ED)

Why do I say this? Well, Keynes himself said it.

“The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.
It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment.” (Keynes, General Theory, Chapter 16)

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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