Investment defined
Definition
Investment (I): spending by firms on capital goods such as machinery, buildings and technology.
Gross investment: total spending on capital goods before any allowance for wear and tear.
Net investment: gross investment minus depreciation, the true addition to the capital stock.
Depreciation (D): the value of capital used up in production.
- Only net investment expands the economy's capital stock, because gross investment first has to cover depreciation; spending above that replacement level is what actually adds productive capacity.
Example
- If a firm spends £100,000 on machines but £100,000 worth wears out, net investment is zero, so the capital stock is unchanged despite the spending.
Growth and confidence
Definition
Business confidence: firms' optimism about future sales and profits.
Animal spirits: Keynes's term for the instinctive optimism or pessimism that drives investment beyond what current data alone would justify.
- A faster rate of economic growth encourages investment because firms expand capacity to meet the rising demand that growth signals.
- Stronger business confidence raises investment because capital projects only pay off if the extra output can be sold, so firms commit only when they expect strong future sales and profits.
- Animal spirits make investment volatile: a wave of pessimism can cause firms to postpone projects even when interest rates and current demand are unchanged, as happened in the 2008-09 recession.
Finance and policy
Definition
Interest rates: the cost of borrowing funds and the opportunity cost of using retained profit.
Access to credit: how readily firms can obtain finance from banks and financial markets.
- Higher interest rates reduce investment because they raise the cost of borrowing and the opportunity cost of retained profit, so fewer projects clear the hurdle of an expected return above the cost of finance, which is why the Bank of England's Bank Rate rises through 2022 deterred some firms from financing new capital projects.
- Easier access to credit raises investment because firms can finance projects they would otherwise shelve, whereas a credit crunch, as in 2008-09, forces even profitable projects to be cancelled.
- Stronger demand for exports encourages investment because firms build capacity to serve growing overseas markets; a weaker pound that makes UK car manufacturers more competitive abroad, for instance, can prompt them to invest in extra assembly capacity.
- Government and regulation shape investment through corporation tax, investment incentives such as capital allowances, and the burden of regulation, all of which alter the post-tax return on a project.
Is investment the most volatile part of AD?
- It holds because investment swings more sharply than consumption or government spending: it is driven by animal spirits and confidence, so expectations can turn quickly, and its collapse deepened the 2008-09 recession.
- But investment is only around 15% to 20% of AD, so even a large % swing in it can move total AD by less than a modest change in consumption, which is around 60%.
- On balance investment is the most volatile component in percentage terms, but whether it is the biggest source of AD instability depends on its size relative to swings in the larger components.
Exam technique
- Explain the mechanism, for example how a rate change alters the cost of borrowing, before stating the effect on investment.
- Use animal spirits to explain why investment can be volatile even when interest rates are stable.
Common Mistake
- Do not confuse gross with net investment, as only net investment expands the capital stock.
- Investment means spending on capital goods, not saving money in a bank.
Self review
- What is the difference between gross and net investment?
- How does the rate of economic growth influence investment?
- What did Keynes mean by animal spirits, and why do they make investment volatile?
- Why do higher interest rates reduce investment?
