Investment – The spending of money on capital goods by firms in order to increase their productive possibility.


A) Distinction between gross and net investment

Net investment takes into account the depreciation of capital. This is in contrast to gross investment which measures investment before depreciation is taken into account. For example, as machinery gets older its value is likely to depreciate and therefore it isn’t worth the same as it was new. To find out the net investment you would take the gross investment and subtract it by the depreciation.


B) Influences on investment:

The rate of economic growth

An increase in the rate of economic growth (the accelerator effect) signals to firms that the demand for their goods/services is going to increase in the near future. Therefore, firms need to have enough productive capacity to respond to this increase. In order to do this, they will have to increase the amount of money that they invest in capital goods. Firms will be willing to make this invest in order to maximise their future profits.


Business expectations and confidence

If firms believe there will be an increase in the demand for their goods/services in the future then their marginal propensity to invest is likely to increase. This is because they will need to increase their productive capacity in order to meet the increase in demand that is likely to take place in the future. In addition to this, if firms believe that their profit levels will increase, then they will be more confident to use their money for investment purposes. As a result of this, when business confidence is high, investment within the economy increases thus leading to an increase in AD.


Keynes and ‘animal spirits’

The term animal spirits was used by Keynes in order to describe the emotional and instinctive side of humans, thus helping to understand the level of confidence or pessimism conveyed by consumers and firms and why this influences their decision either to save or spend/invest. The term was founded by Keynes during the great depression and links psychological changes in both consumers and firms to the state of spending/investment in the economy. This has had an influence on macroeconomic policy decisions made since the great depression took place. In times of strong economic growth and rising markets, entrepreneurs are willing to take risks as their “animal spirits” are strong. This leads to an increase in Aggregate demand as investment increases. However, when animal spirits are weak, aggregate demand will fall as only strong willed entrepreneurs would be willing to put their money at risk.


Demand for exports

If the demand for exports increases, then so will the demand for domestic goods/services. In order to match this increase in demand, some firms may have to increase their investment in capital goods in order to increase their productive potential, consequently allowing them to meet this demand in the future. In addition to this, the increase in the demand for exports also increases firms’ revenue and most likely profits. This will give firms an increased level of retained profit thus giving them more profit to invest.


Interest rates

The majority of investment by businesses is financed through bank loans. A decrease in interest rates allow firms to borrow money at a lower rate than before, as they do not have to pay as much money back on top of the initial loan.

Read more…