Explain why investment (I) varies more from year-to-year than consumption (C).
Lets understand the factors on which the investment depends:
1. Marginal efficiency of capital: It is the expected rate of return on investment at a particular point of time.
Now, if we think on two terms that we have just said in the definition of marginal efficiency, that is expected rate and point of time then we can see why investment tends to be volatile. Expected return means that an investor calculate the return on investment depending upon all the conditions that can influence that particular investment. For example. if you want to open a shop then factors such as the location, population, pre existing competitors will taken in consideration before setting up a shop. Moreover these conditions can be influenced any time in the future also which makes investment even more volatile, like suppose people coming to the shop increases as a new institute sets up near to your shop, leading to increase in return. thus with time it also changes. although we calculated expected return at a particular point of time. Hence, you can analyse how volatile it can be, and there are multiple factors working together in real life scenario.
2. Interest rates: Interest rate are the cost of borrowing money. If its high then we can buy less amount of money from the market, either from money lenders, bank, etc. as we have to return the principal amount (loan amount) with interest.
Now, if the cost of borrowing money increases then there will be a sure decline in people purchasing money for further investment. The more the absolute amount of money the more will be the absolute interest rate amount.
Thus interest rate directly influences Investment. Interest rate and investment has a negative relationship.
Interest rate depends on several factors and this is the reason for investment being volatile.
Factors such as:
- Supply and demand of credit. More supply means easy availability of money and thus will be at lower interest rate.
- Government can solely influences investment by purchasing away money from the economy and leaving less money for private investors. the phenomenon is called crowding out effect.
- Inflation: The higher the inflation the more likely the interest will increase because the lenders want more money on their savings, as their purchasing power has gone down due to existing inflation.
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