Investment and aggregate demand

Detail

Background: why Keynes put investment at the centre

• The Great Depression (from 1929) is the setting for this model.
• In the USA, unemployment rose from about 3% to 25% between 1929 and 1933, and output fell by about one-third. [NCERT leec101]

• Classical economics said markets clear on their own. It could not explain why so many workers stayed unemployed for years.

• John Maynard Keynes answered in The General Theory of Employment, Interest and Money (1936). [5]

• Its key idea is the principle of effective demand. The level of output and jobs is set by aggregate demand, not by the wage rate (the price of labour). [5]

• The book also introduced the consumption function and liquidity preference, and gave new weight to the multiplier and the marginal efficiency of capital (the return a firm expects from a new machine or building). [5]

• Investment was the key variable for Keynes. He treated it as the most important force behind total spending, even though it was usually only one-fifth to one-sixth of total spending. [5]

What "investment" means in macroeconomics

• Investment: spending that adds to the economy's stock of capital. It has two parts.
• Additions to physical capital (also called fixed capital formation). Examples are machines, factory buildings, roads and bridges. Anything that raises future productive capacity (the ability to produce more later) counts.

• Changes in inventory (also called change in stocks). These are the goods a firm has produced but not yet sold, plus raw materials held in store.

• Investment is not the same as buying shares or gold. Buying an existing share only moves ownership from one person to another. No new capital is created, so this is a financial investment, not an economic one.

• Investment goods are final goods, not intermediate goods.
• An intermediate good is used up within the year to make something else. Cotton used to make shirts is an example.

• A machine is not used up in one year. It gives services for many years, so it is counted as a final good in GDP.

• Planned and unplanned inventory change.

• Ex ante means planned or intended. Ex post means actual or realised.
• Suppose firms plan to add ₹10 crore to stocks, but sales are weaker than expected and ₹25 crore of goods stay unsold. Planned inventory investment is ₹10 crore. Actual inventory investment is ₹25 crore. The extra ₹15 crore is unplanned inventory accumulation.
• This gap is how the model reaches equilibrium. Firms that see unsold stock pile up cut production.

India's investment in national accounts (latest official data)

• India's GDP identity (expenditure approach): GDP = PFCE + GFCE + GFCF + CIS + Valuables + Exports − Imports. [2]
• PFCE (Private Final Consumption Expenditure) corresponds to C in the model.
• GFCF (Gross Fixed Capital Formation, i.e. spending on new fixed assets) + CIS (Change in Stocks) + Valuables correspond to I.
• GFCE (Government Final Consumption Expenditure) corresponds to G.

• Exports − Imports correspond to X − M.

• Size of investment (current prices, share of GDP): [2]

Item	2022-23	2023-24	2024-25 (PE)
GFCF (fixed investment)	31.2%	30.4%	29.9%
Change in Stocks (inventory)	1.1%	1.5%	1.5%
PFCE (consumption)	61.5%	60.2%	61.4%
GFCE (government consumption)	10.3%	10.3%	10.0%

• Size of GDP: nominal GDP was ₹330.68 lakh crore (2024-25, Provisional Estimates). GFCF was about ₹98.86 lakh crore at current prices (2024-25). [2]
• Growth: real GFCF grew 7.1% in 2024-25, down from 8.8% in 2023-24. Real PFCE grew 7.2% in 2024-25, up from 5.6% in 2023-24. [2]
• The inventory part swings the most.
• Real Change in Stocks grew 53.4% in 2023-24 but only 4.5% in 2024-25. [2]
• In 2023-24, quarterly growth in inventory ran between about 46% and 60%. In 2024-25 it ran between about 2% and 8%. [2]
• Real GFCF growth moved within a range of about 5.2% to 11.7% across these eight quarters. [2]
• This fits NCERT's point that investment is the unstable part of demand.

Autonomous investment (Ī)

• Autonomous investment (Ī): investment that does not depend on the current level of income (Y).
• The model's assumption (NCERT equation 4.2): ex ante investment is I = Ī, where Ī is a positive constant.
• On a graph, investment is a horizontal straight line at height Ī. It stays at the same level whether income is high or low.
• In reality, investment depends on other things. The model keeps these outside Y, and a change in them shifts Ī.
• The interest rate, which is the cost of investible funds (the price a firm pays to borrow for a project).
  • Interest rate rises → loans cost more → fewer projects make a profit → investment falls.
• Availability of credit.
  • Banks lend easily → firms can fund projects → investment rises.

• Business expectations. Keynes called these "animal spirits": confident firms invest more.

• Indian example of the interest-rate channel:

• Repo rate: the interest rate at which the RBI lends money to commercial banks for a short time. [4]
• On 6 June 2025, the RBI's Monetary Policy Committee cut the repo rate by 50 basis points to 5.50% (1 basis point = 0.01 percentage point). [4]
• The chain works like this: repo rate cut → banks can lower their loan rates → firms borrow more cheaply → Ī rises → the AD line shifts up.
• The RBI expected investment to pick up because of higher capacity utilisation (factories using more of their machines), stronger balance sheets of banks and companies, and the government's capital expenditure push. [4]

Why investment is the "swing component"

• C̄ (autonomous consumption) is the spending people must do even at zero income, for food and other basic needs. It is fairly stable.
• Ī goes through periodic fluctuations (regular ups and downs), because expectations, credit and interest rates keep changing.
• Result: changes in investment drive most booms (fast growth) and slumps (sharp slowdowns).
• Investment falls → demand for machines and buildings falls → output and jobs in those industries fall → incomes fall → people consume less. The multiplier then makes the fall larger.

Aggregate demand in the two-sector model

• Two-sector model: an economy with only households (which consume) and firms (which produce and invest). There is no government and no foreign trade.
• Aggregate demand (AD): the total ex ante (planned) demand for final goods in the economy.
• Formula:
• AD = C + I
• C = C̄ + cY. Here c is the marginal propensity to consume (MPC), the share of each extra rupee of income that is spent. 0 < c < 1.
• I = Ī

• So AD = C̄ + Ī + cY = Ā + cY

• Autonomous expenditure (Ā): all spending that does not depend on income.

• Ā = C̄ + Ī in the two-sector model.

• It grows to include G, the transfer effect and exports when those sectors are added.

• Worked example:

• Take C̄ = ₹100 crore, Ī = ₹50 crore and c = 0.8.
• Then Ā = 100 + 50 = ₹150 crore, and AD = 150 + 0.8Y.
• At Y = ₹1,000 crore, AD = 150 + 800 = ₹950 crore.
• If Ī rises by ₹20 crore to ₹70 crore, then AD = 170 + 0.8Y. At every income level, AD is now ₹20 crore higher.

The AD graph

• AD is the vertical sum of the consumption line and the investment line. At each income level, you add C and Ī one on top of the other.
• NCERT's figure:
• OM = C̄, the intercept of the consumption line.
• OJ = Ī, the height of the horizontal investment line.

• OL = C̄ + Ī = Ā, the intercept of the AD line.

• Slope: AD is parallel to the consumption function because both have the same slope, c. Adding a constant Ī only lifts the line. It does not tilt it.

• Shifts: a change in Ā (for example, a rise in Ī) shifts the AD line in parallel, up or down. A change in c would instead change the slope.
• AD shows ex ante (planned) demand, not actual sales.

Adding government (three-sector model)

• Three-sector model: households + firms + government.
• Formula: Y = C̄ + Ī + G + c(Y − T)
• G = government spending on goods and services.

• T = taxes. Y − T = disposable income (the income people have left to spend after tax).

• Rearranged: AD = (C̄ + Ī + G − cT) + cY. The term G − cT simply adds to Ā.

• A tax of T lowers consumption by only cT, not by the full T, because people would have saved part of that money anyway.

• Worked example:

• Take C̄ = 100, Ī = 50, c = 0.8, G = 60 and T = 50.
• Then G − cT = 60 − 40 = 20.

• So Ā = 100 + 50 + 20 = 170, and AD = 170 + 0.8Y.

• No qualitative change: the AD line stays parallel with slope c. It only starts at a higher intercept.

• Real-world link: government capital expenditure is public investment. In India it was ₹2 lakh crore (2014-15) and ₹11.2 lakh crore (BE 2025-26), and it is budgeted at ₹12.2 lakh crore for 2026-27. [3]

• The fiscal deficit (the gap between government spending and its non-borrowed income) is budgeted at 4.3% of GDP (BE 2026-27), down from 4.4% (RE 2025-26). [3]

• GDP and National Income: when there are no indirect taxes and no subsidies, GDP ≡ National Income. NCERT therefore uses the two terms interchangeably in this model.

Adding trade (four-sector or open model)

• Four-sector model: households + firms + government + the rest of the world.
• Formula: AD = C̄ + Ī + G + c(Y − T) + X − M
• X = exports, bought by foreigners. They depend on foreign income, so the model treats them as autonomous.

• M = imports. Imports rise with domestic income, because richer households buy more foreign goods.

• Why this matters: when part of each extra rupee goes on imports, that demand leaks abroad and does not support home output. This is the root of the open-economy leakage covered in Section 6 (the multiplier becomes smaller).

• India's trade in GDP (current prices, 2024-25): exports were 21.2% of GDP and imports were 23.5% of GDP. So net exports (X − M) were negative and reduced AD. [2]

Economy	Aggregate demand
Two-sector	C̄ + Ī + cY
Three-sector	C̄ + Ī + G + c(Y − T)
Four-sector (open)	C̄ + Ī + G + c(Y − T) + X − M

Prelims Hooks

• Investment = additions to physical capital (machines, buildings, roads) + changes in inventory. Buying existing shares is not investment in national income accounting.
• Investment goods are final goods, not intermediate goods, because a machine gives services over many years.
• In the Keynesian model, I = Ī is autonomous and plotted as a horizontal line. A change in the interest rate shifts it; it does not move along it.
• AD = C̄ + Ī + cY = Ā + cY. The AD line is parallel to the consumption function (slope = MPC, c). Its intercept is C̄ + Ī (OL = OM + OJ).
• A rise in autonomous investment causes a parallel upward shift of AD. A rise in MPC makes AD steeper.
• In the three-sector model, G − cT is added to autonomous expenditure. A tax of T cuts consumption by cT, not T.
• India's expenditure-side GDP: GDP = PFCE + GFCE + GFCF + CIS + Valuables + X − M, as published by MoSPI/NSO. [2]
• GFCF was 29.9% of GDP at current prices in 2024-25 (PE). PFCE was 61.4%. [2]
• The repo rate was cut by 50 bps to 5.50% on 6 June 2025 at the 55th MPC meeting. The SDF (Standing Deposit Facility) rate is 25 bps below repo and the MSF (Marginal Standing Facility) rate is 25 bps above. [4]
• Trap: "Keynes held that employment is set by the wage rate." This is false. He held that it is set by aggregate demand (General Theory, 1936). [5]

Mains Points

• Investment is the swing factor, so policy targets it.
• Consumption is stable, while private investment rises and falls with expectations and credit.
• India has used public capex as an autonomous injection. It rose from ₹2 lakh crore (2014-15) to ₹12.2 lakh crore (BE 2026-27) to support demand and draw in private investment. [3]

• This must be balanced against fiscal consolidation, with the fiscal deficit at 4.3% of GDP (BE 2026-27). [3]

• Monetary and fiscal policy together.

• A repo rate cut (5.50%, June 2025) lowers the cost of funds, which works on Ī. [4]

• Rate cuts alone may not lift investment if capacity utilisation is low or company balance sheets are weak. This is why the RBI links an investment revival to capacity utilisation, balance sheets and government capex. [4]

• The investment rate has slipped.

• GFCF was 31.2% (2022-23), 30.4% (2023-24) and 29.9% (2024-25) of GDP at current prices. [2]

• A falling investment share can limit future productive capacity, which matters for the goal of Viksit Bharat (the target of a developed India by 2047). Arguments can link this to private capex, credit flow and ease of doing business.

• Open-economy leakage.

• Imports (23.5% of GDP) exceeded exports (21.2%) in 2024-25. [2]
• Part of any rise in domestic demand leaks abroad, which weakens the multiplier.
• This supports the case for domestic manufacturing and capital-goods capacity, but it has to be weighed against the gains from trade and the cost of protection.