Investment is the most important component of aggregate demand. Now the question arises as to how the decision relating to the volume of investment is taken at any point of time or how is it decided as to how much amount of money should be invested?
The decision of private entrepreneurs relating to volume of investment is motivated by the objective of earning profits. A private entrepreneur will think of establishing a new factory or expanding the existing factory only when he expects to earn profit from this new investment or activity. Therefore, the objective of earning profit is the most important variable factor affecting private investment.
The three elements important in understanding investment are:
(i) Revenues
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(ii) Costs
(iii) Expectations.
(i) Revenues:
This means the additional revenue which a firm may get after the investment. A firm will think of investing only if it gets additional revenue from investment.
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(ii) Costs:
Here costs means the cost of buying capital assets due to investment such as cost of buildings, machines, equipments etc. The difference of revenue and cost is called net revenue.
(iv) Expectations:
This means what does a firm think about the profit or net revenue from the investment. It is nothing but merely a guess work about the profitability of investment. A firm will think of investment only when it thinks that it will be a profitable exercise.
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(v) Decision to invest:
The most important factor deciding the volume of investment is the rate of interest. Money is required for funding the costs of capital assets. We know there is inverse relationship between rate of interest and the demand of funds. Using interest rate, we have to find out net profit rate in the following manner:
Net Profit Rate = Net Revenue Rate – Rate of Interest