30 Investment

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Key points:

Investment is the purchase of capital goods which are then used to create other goods and services. It differs from saving, which is the creation of financial obligation

The level of investment is determined by many variables including interest rates, changes in NI, costs, business expectations and confidence, the state of world economy, access to credit, retained profit, government policy and regulation

A definition of investment:

Economists use investment precisely. Investment is the addition to the capital stock of the economy (factories, machines, offices and stocks of material) which are then used to produce other goods and services

For economists, investment only takes place if real products are created. For example putting money into a bank would be saving, the bank buying a computer to handle your account is investment. Example 2: Buying shares in a new company would be saving, buying new machines to set up a company is investment

There is distinction between gross investment and net investment. The value of capital stock depreciates over time as it wears out and is used up = depreciation or capital consumption

Gross investment measure investment before depreciation. Net investment is gross investment minus the depreciation

Another distinction is made between investment in physical capital and human capital. Investment in human capital is investment in education and training of workers. Investment in physical capital is investment in factories. Physical investment only counts towards AD

Investment is made by both public and private sector. Public sector investment is constrained by political considerations

The rate of interest:

A variable affecting level on investment is interest rates

Some investment is financed by firms borrowing money. Interest paid on a load is then part of the cost. The higher the interest rate, the lower the profit that can be made from the investment. At some point, interest rates may be so high that the investment project is unprofitable. SO a rise in interest rates therefore reduces the number of profitable investment projects so there will be less investment. The lower the interest rate, the more investment will be profitable so there will be more investment

Some investment is financed by retained profit (savings firms keep and don't distribute to owners). The higher the interest rate on savings, the more attractive it is for firms to save than invest. The lower the interest rate, the greater incentive for firms to run down savings and invest

The rate of e. growth - the accelerator theory:

If the same product and amount is being produced in an economy every year, the level of investment will remain the same

Firms will invest to replace physical capital that have worn out and no longer profitable BUT there will be no need to increase investment beyond this

However, if the economy is growing, firms need to increase their investment to have the capital equipment to produce more goods and services

If the economy is shrinking, like in a recession, firms won't need to replace investment goods that have worn out as with lower output, they will need less capital equipment. SO investment falls when economic growth is negative

The idea that investment is linked to changes in output of income is the accelerator theory. It can be expressed by the equation: It = a (Yt - (Yt-1))

It= investment in a time period a= the accelerator coefficient, the capital-output ratio Yt - Yt-1 = the change in real income during year t

The capital-output ratio is the amount of capital needed in the economy to produce a given quantity of goods

Costs:

Private sector firms need to make a profit, they need to be able to sell the products made from an investment. They also have to keep their costs per Increases in costs will reduce the profitability or rate of return from an investment

Costs and predictions about what will happen over the lifetime of the investment are important to firms considering whether to invest or not.

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Business expectations and confidence:

If firms expect their sales to increase, they are more likely to invest in new capital equipment

In a boom, investment is likely to rise due to higher demand and increased output

If firms lose confidence and expect sakes to fall, they are likely to cut back of investment plans

Keynes used the phrase 'animal spirits' to describe the mood of managers and owners of firms. He argued that animal spirits are confidence and not something that can easily be measured

If enough firms feel confident in the future, investment will increase to raise income and output in the whole economy

The world economy:

If the world economy is booming, demand for exports is likely to increase. This should lead to a rise in domestic investment

A worldwide recession will reduce demand for exports so exporting firms are likely to cut back. This has a knock-on effect on other firms, reducing their sales and willingness to invest

Access to credit:

Some investment is financed through borrowing. The amount of money available for borrowing varies

If banks are less willing to give loans due to fear the firm will not be able to repay with the interest, firms can be turned down by the banks

Retained profit:

Retained profit is profit kept back by firms and not distributed to shareholders

Some economists argue firms and small firms in particular tend not to consider the opportunity cost of investment

Firms can also be risk averse and not want to borrow money in fear the investment fails to make profit

If money is available, firms will invest so if retained profit is low, firms tend not to invest

The influence of government and regulations:

Govt. can influence investment across the economy and in particular sectors

If corporation tax were cut, it would increase investment as it cuts costs for a firm on investment which raises the profitability,

Govt. can also increase investment by guaranteeing loans made by banks to firms, if the firm fails to repay the money the govt. pays the bank instead. It encourages banks to lend money on higher risk projects

Regulations also affect investment, Highly regulated economies often discourage investment as regulation resend to increase costs and so reduces profitability

Regulations can also directly prevent firms investing as it isn't permitted by regulations

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Key terms:

Investment: the addition to the capital stock of the economy

Gross investment: the addition to capital stock, to replace existing capital stock that has depreciated and the creation of additional capital

Net investment: gross investment - depreciation

Depreciation or capital consumption: the value of capital stock which has been used up or worn out

Retained profit: profit kept back by a firm for its own use and not distributed to shareholders to used to pay taxation

Accelerator theory: the theory that the level of investment is related to changes in income

Accelerator coefficient: the capital-output ratio

Capital-output ratio: the ratio between the amount of capital needed to produce a given quantity of goods and the level of output

Animal spirits: business confidence, the mood of managers and owners of firms about the future of their industry and the wider economy