For a lay man, investment refers to buying existing physical assets such as a residential property or office building, etc. But in macroeconomics, the word investment has a specific meaning- “Investment is the flow of spending that adds to the physical stock of capital”.(definition sourced from Dornbusch, Fischer and Startz).

Some features of investment are-
 Investment involves the sacrifice of present consumption and the production of investment goods.  It is a flow concept.
 It is the most volatile component of aggregate demand.
 It is one of the determinants of long run productive capacity of the economy.
 Investment affects both the aggregate demand and aggregate supply as an increase in investment expenditure increases aggregate demand and by adding to the productive capacity it increases aggregate supply.
 Investments are generally self-financing. This is so because, when investments are well planned, then future returns from the creation of new assets shall pay for its cost and even provide some profit.  Investments are self-terminating because when the creation of the asset is complete, the investment stops.

Investment can be divided into three sub sectors: - business fixed investment, residential investment and inventory investment. All these three sub sectors are subject to fluctuations.
Business fixed investment
By business fixed investment we mean that the investment goods are purchased by the firm for producing further goods and that the expenditure incurred on them is for capital and will stay put up for long. In other words this is the money invested by the firm in further pursuit of its production activities. Examples of business fixed investment include: - machinery, plant and building, computers, telephones, business vehicles, electronic equipments at workplace, etc.
This investment forms the largest component of all types of investments (sourced from Mankiw).
Business fixed investment, as a share of GDP, falls sharply, before and during recessions and then, starts rising as recovery kicks in (sourced from Dornbusch et. al).

There are different methods which can be employed by the firm to source its investments. These are-
 Retained earnings (those profits which are not paid out to the shareholders)
 Bank loans
 Bond market
 Equity finance
Out of these sources, one source which stands out due to its predominance in financing is retained earnings. There is a close link between the earnings of a firm and its dividend and investment decisions. This is because in case of non-availability of outside funds, the decision to invest would be determined by the assets in hand. Therefore, the state of a firm’s balance sheet, and not just the cost of capital, is important in determining its investment decisions.

A firm’s investment decision will depend upon the following-
 Interest rate
 Savings out of past earnings
 Current profits
Having said so, the cost of capital is still important in a firm’s investment decision because the firms that retain earnings have to consider the alternative of holding financial assets and earning interest rather than investing in plant and equipment.

Residential investment 
Residential investment includes the purchase of new housing both by people who plan to live in it and by landlords who plan to rent it to others (definition sourced from Mankiw). Housing can be distinguished from other assets due to its long life. Also investment in housing in any one year is only a small percentage of the existing stock of houses.
Interest rates affect residential investments. Therefore, the state by altering its monetary policy via interest rates (both real and nominal) can affect the residential investments made in the economy. This is because; most house purchases are financed by loans. The cost of owning a house rises with increase in interest rates.

Inventory investment
Inventories include stock of raw materials, work in progress and finished goods held by the firms in storage to meet specific objectives. They are an inevitable part of production and distribution processes and represent the capital which is tied up in unsold goods. Reasons why firms hold inventory
 Firms hold inventories to smoothen out their production processes. While the demand may fluctuate during the year, the firm continues production evenly throughout the year, building inventories in times of low demand and selling out of inventories in times of high demand.
 Many suppliers offer quantity discount. Therefore, firms like to buy in bulk and keep inventories of material in order to avail these discounts.
 Large inventories can help a firm avoid a stock out situation.
 Sometimes the production process of a good is such that the buildup of inventories is natural to its production. This is true for those goods whose production process takes a huge time to complete. Till the time the good is not produced, it is inventory.
 When certain goods are bought and/ or sold in batches, holding of inventory becomes inevitable. Inventory sale ratio and factors affecting it The ratio of manufacturing inventories to sales is called the inventory sales ratio. It depends on the following factors. 


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