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Investment (I)

a) Gross and net investment

Investment is spending by firms on capital goods over a period of time and at a given price level (KEY DEFINITION). In economics, investment is only when there is an addition of capital stock to the economy, for example, when a firm buys new machinery to aid the production process. Buying stocks and shares would not be classed as investment, but savings, as in doing so there is no additional capital stock added to the economy.

Capital goods wear down over time due to consistent use, for example machinery becoming older and less efficient over time. This means that the value of these goods depreciates over time. Gross investment is the amount of investment ignoring for depreciation over time, whereas net investment is gross investment minus the value of depreciation. In the UK, depreciation accounts for 75% of all gross investment.

It is also useful to understand the difference between human and physical capital. Human capital investment is the investment into the workforce via education and training. Physical capital investment is investment into capital goods. Because human capital investment does not provide additional capital stock to the economy, physical capital investment is what is represented in the aggregate demand statistics.

b) Influences on investment

Business confidence - If the enterprise factor of production is concerned about the current state of the economy, they will fear that their profits will be reduced. In order to conserve profits, they will cut investment as a precaution. Contrastingly, if business owners are confident in the future of the economy, they will invest more. In the 1930's, John Maynard Keynes referred to the feelings of managers as "animal spirits", and that levels of investment depended on their mood about the firms future.

Interest rates - Because of the large amount of up front money needed to fund projects, the majority of investment is financed through borrowing. If interest rates rise, the cost of borrowing increases. This means that there is now a higher opportunity cost for firms to invest, as they need to return a higher revenue to make the same profit as before. About 70% of UK investment involves the use of retained profits. Higher interest rates again increases the opportunity cost of investing, as this money in a savings account is now receiving more interest than before.

Government incentives and regulation - Government policies, such as tax breaks and subsidies, can lead to further investment. Government regulations can increase the complexity of investment, deterring many firms from doing so. For example, due to the complexity of the UK's planning system, it takes on average 43 weeks for a new development to be approved. This longer time increases administrative costs, disincentivizing investment.

Access to credit - If there is less access to credit in an economy, firms will have less opportunity to invest through borrowing money. Because most investments are financed this way, investment overall will fall significantly.

Risk - If investments are riskier, then few are likely to invest out of fear of gaining no returns. In times of economic downturn (recessions), investment is riskier as firms are less likely to see a return. Also, if an investment is risky, firms are less likely to secure a loan from the bank to finance it, therefore reducing investment.

Technological advances - Improvements in technology will result in faster or higher quality production, therefore increasing profits through more efficiency. Investing in said technology would likely be a safe investment, so more firms will invest. Also, in order to stay competitive, when new technology does come out firms ought to invest.

Use the word BIGART as a mnemonic device for remembering the influences on investment!

The accelerator theory

The accelerator theory states that the level of investment is linked with the changes in output or income in an economy. If an economy is expanding, firms will need to invest in more capital in order to keep up with the extra demand for goods and services. Contrastingly, if there is a recession, firms will reduce investment in order to conserve profits. The accelerator theory can be shown using this equation:

It = a ((Yt) - (Yt-1))

Where It is the investment over a time period, ((Yt) - (Yt-1)) is the change in real income over a time period t, and a is the accelerator coefficient or the capital-output ratio.

The capital-output ratio is the amount of capital needed to produce a given quantity of goods in the economy. For some context, if £500 of capital is needed to make £250 of goods, then the capital-output ratio is 2.

To help revise this, click the button for my condensed flashcards!

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