Determinants of investment

Investment rate in the economy is mainly influenced by two factors. They are:

1. Marginal efficiency of capital

Marginal efficiency of capital means its productivity efficiency. In general, marginal efficiency of capital shows the possible income from the additional capital investment. Any entrepreneur, before investing compares the prospective yield from the investment and the interest for the loan taken from the investment. If the rate of return from the output is more than the rate of interest for the capital, than the entrepreneur will invest. But, if the rate of return is less than the rate of interest, than the entrepreneur will not invest.

2. Rate of interest

The amount of investment is influenced by the marginal productivity of capital and the rate of interest. However, government investment is not influenced by these factors. Only private investment and entrepreneurs are influenced by these factors. But both of these factors don’t have the same influence on the investment. The main cause for this is that, in the short run, the rate of interest is fixed. Therefore, investment is more influenced by the marginal productivity of capital than the rate of interest. When marginal productivity of capital is more, investment is possible despite the high rate of interest. Likewise, when marginal productivity of capital is low, investment will still be discouraged despite the low rate of interest. Therefore, marginal productivity of capital depends upon the expected income in the future.