2.2.3 Investment (I) Flashcards
Investment
Investment is the addition of capital stock to the economy i.e. machines and factories used to produce other goods and services. It is only seen as investment if real products are created so buying a share in a company would be saving but buying new machinery is investment.
Gross vs Net investment
Machinery depreciates (loses its value) over time as it wears out or gets used up. Gross investment is the amount of investment carried out and ignores the level of depreciation, whilst net investment is gross investment minus the value of depreciation.
- For example, if a firm was to buy 5 new machines then the gross investment would be the value of these 5 machines but if they also got rid of 2 old machines then the net investment would be the value of the 5 machines minus the value of the 2 old machines. The distinction between net and gross investment is important as in the UK depreciation accounts for about 75% of gross investment.
Influences on investment
- Rate of economic growth
- Business expectations and confidence “Animal spirits”
- Demand for exports
- Interest rates
- Influence of government and regulations
- Access to credit
- Retained profit
- Technological change
- Costs
Rate of economic growth: influence on investment
In a growing economy, there will be higher levels of investment as businesses would be more confident about their investments and the higher demand would lead to a higher return rate on the investment. For example, buying a new machine would lead to more products being made, but if the economy was declining these products wouldn’t be bought so there would be no or little return on the investment. On top of this, a growing economy needs more investment in order to cope with the higher levels of demand. If the same products and the same output is being produced every year, and no more is demanded, investment will stay the same as firms only have to replace old machines. However, if the economy is growing, firms will need to increase investment to match the level of demand and if it is shrinking, firms will not need to replace their old machines and so investment will fall.
- ** This is called the accelerator theory: the investment over a period of time is the change in real income times the capital-output ratio. The capital output ratio is the amount of investment needed to produce a given amount of goods. Thus, if incomes rise, the level of investment will rise.
Accelerator theory **
This is called the accelerator theory: the investment over a period of time is the change in real income times the capital-output ratio. The capital output ratio is the amount of investment needed to produce a given amount of goods. Thus, if incomes rise, the level of investment will rise.
Business expectations and confidence “Animal spirits”: influence on investment
When businesses are confident about the future and expect future growth, investment will increase as they want to prepare for the future. If they are fearful of the future, then they will not invest money in new ideas or machinery. John Maynard Keynes used the term ‘animal spirits’ to describe the feeling of managers and owners of firms on whether their investment would be profitable. He argued that it is difficult to measure.
Demand for exports: influence on investment
If the world economy is booming, demand for exports is likely to increase and therefore exporting firms’ investment is likely to increase to cope with this extra demand. This will have a knock-on effect and encourage other firms to increase their investment.
Interest rates: influence on investment
Most investment is done through borrowing. High interest rates mean that borrowing is more expensive, so a business needs to be more confident of good profits in order to cover the extra costs of borrowing. Other investment is done through retained profits or savings. A rise in interest rates increases the opportunity cost of a business using retained profits as they are able to get higher interest payments than before. Keynes’ Marginal Efficiency of Capital (MEC) graph shows how higher interest rates will lead to a fall in investment. This displays the expected rate of return from an investment at a particular given time. If interest rate is at 10% then firms need an expected rate of return which is at least equal to 10% to make it worthwhile.
Influence of government and regulations: influence on investment
Governments can encourage investment by their own policy decisions. For example, they could offer tax breaks or grants to businesses to try and encourage them to invest. Regulations also affects investment as a highly regulated economy tends to see less investment as regulation increases the cost and time taken to invest, such as planning regulations.
Access to credit: influence on investment
Investment will be lower when an investment has a high risk attached to it, as it means there will be less access to credit and interest rates will be higher. In recessions, it is usually more difficult to access credit as risks are higher and banks become more risk aware, fearing firms will not be able to pay the money back.
Retained profit: influence on investment
Retained profits are the profits kept by a firm and not shared with shareholders or used to pay taxes. Not all firms, particularly small firms, take into account the opportunity cost of investment from their retained profits i.e. the interest gained from keeping it in a bank account. Many firms are also unwilling to borrow money for investment in case the investment fails to make a profit and they are unable to pay it back. Therefore, if firms are making higher retained profits, investment is likely to increase as they have money available to invest.
Technological change: influence on investment
Improvements in technology will improve or speed up production which will increase the level of profitability, meaning the investment has a better prospect of success. Change also means businesses need to invest to keep up with the best technology.
Costs: influence on investment
A rise in the cost of any capital project increases the level of risk that you are taking and therefore leads to lower levels of investment. Also, rises in the costs of making goods, such as the raw materials and wage, will decrease investment as it will reduce profitability. This means firms have less money to invest and decreases the rate of return on their investment.
