The Investment Function
The Keynesian cross is a stepping-stone on our path to the IS-LM model. It is useful because it shows how the spending plans of households, firms and the government determine the economy's income. Yet, we have assumed that the level of planned investment is fixed. We now relax this assumption in our model by introducing a relationship between the interest rate and planned investment:
Because the interest rate is the cost of borrowing to finance investment projects, an increase in the interest rate reduces planned investment. As a result, the investment function slopes downward.