Like consumption, and other spending components of AD, investment is a flow, not a stock. This means it is measured at a rate over a period of time, eg £X billions per year. Investment is spending on buildings, machines, vehicles and other items that will aid the production of goods and services. It also includes spending on inventories, These comprise materials, components, semi-finished and finished goods that will eventually be sold.

The __capital stock __refers to the total value of the nation’s accumulated capital items. As the name suggests, it is a stock, not a flow; its value is measured at a point in time.

__Depreciation __is the loss in value of the capital stock over a period of time. This arises partly because machines and buildings physically deteriorate and wear out. But also technological change can make machines obsolete and worthless.

__Gross investment __is the total spending on investment during a period of time.

Net investment is gross investment minus depreciation, in other words it is the change in the value of the capital stock.

For example, suppose the capital stock at the beginning of the year is £100m. During the year investment spending is £15m. But £8m worth of machines wear out. At the end of the year:

Gross Investment = £15m, Depreciation = £8m, Net Investment = £7m, Capital Stock = £107m.

You can see from this that it is possible for net investment to be negative (the capital stock shrinks) if gross investment is less than depreciation.

Investment, figure 1

Investment and Saving

In everyday speech these terms are used to mean the same things, but to the economist they are different. Investment is spending by businesses and government on real assets that are productive. Saving is simply unspent income. The two are connected, because saving is the main way in which investment is financed. For instance, if I put my saving into a bank account it can be lent by the bank to a business to purchase a machine. The same applies if I buy shares in a company.

Main Determinants of Investment

Investment spending by private firms and government contribute to AD. Government investment in things like schools, hospitals and roads is primarily determined by the long term needs of the economy and society and is subject to political priorities. Private sector investment is largely determined by the anticipation of making a profit, and it is private sector investment that we will discuss here.

Investment, figure 1

Business confidence – Investment is really a speculative activity; no-one knows how the future will turn out, and therefore how much profit (or return) on investment will be made. Business confidence (whether firms expect sales to improve, worsen or stay the same) is probably the most important single influence on investment. It can fluctuate wildly. Since the Brexit referendum, investment has plunged as firms are uncertain about the future, for instance. Keynes used the term ‘animal spirits’ to describe the prevailing mood of business optimism/pessimism.

__Interest rates __– Firms compare the anticipated profit from investment, as a % of the sum spent, with the rate of interest, which is the cost of financing the investment. For instance, if the investment is expected to yield an annual profit of 8% and interest rates are 6%, the investment is worthwhile, but not if interest rates rose to 9%. At lower rates of interest, investment will rise, as more investment projects will be profitable.

Note that the rate of interest will still be an important consideration for firms even if they can finance the investment from __retained profit __(profit kept in the bank rather than distributed to shareholders as a dividend). This is because the rate of interest is the opportunity cost of capital; the return that could have been earned in interest by keeping the money in the bank instead of buying machines/buildings.

__Availability of credit __– Before the banking crisis in 2007/8 banks made credit widely available to firms, often without conducting a proper risk assessment of the borrowers. After the crisis bank lending, especially to businesses fell sharply, as banks were much more reluctant to take risks, fearing that some borrowers might default.

The rate of economic growth – The accelerator principle shows that it is the rate of growth, rather than the actual level of AD that is important in determining investment. To understand this we need to distinguish between replacement investment, which is needed to replace capital items that have depreciated (worn out), and net investment, which is required to increase productive capacity.

Suppose the economy has, for the last 10 years had stable AD at £100m per year. Suppose also that the capital stock consists of 100 machines, each of which can produce a maximum of £1m worth of output per year, and each machine lasts 10 years. Machines cost £5m each. Provided AD does not change, the only investment needed in the next year will be to replace the 10 machines that were purchased 10 years ago. This will cost a total of £50m.

In the following year, the economy grows by 5%, so AD is now £105m. Businesses will now need to replace 10 machines that wore out (replacement investment) in the previous year, plus an additional 5 machines to produce the extra £5m of output.

So although the economy has grown by only 5%, gross investment has increased by 50% (£15m instead of £10m). In other words, changes in AD are accelerated (magnified), by the time they feed through to investment.

The same principle applies when the economy slows down. A slowdown in the rate of growth will lead to a fall in gross investment, even though the economy is still growing (but more slowly than before).

If, in the above example, growth slowed to approximately 2% in the year after, so AD rose to £107m, we would still need to replace the 10 machines that will have worn out, but need only £2m worth of additional machines (less than half a machine). So gross investment would be £12m, compared to £15m in the previous year.

The accelerator principle helps us to understand why investment spending tends to fluctuate more than other kinds of spending.

Capital/output ratio_ – _This refers to the amount of capital spending required to generate an additional £1’s worth of output per year. In the above example, machines cost £5m and generated output of £1m, so the capital output ratio is 5. It follows that if capital goods fall in price, and/or become more productive, the capital output ratio will fall. This would mean that less investment is required to maintain or increase output.

Demand for exports_ – _About a quarter of U.K. GDP is exported. If the world economy is booming, this will generate additional demand for U.K. goods and services, and vice versa if the world economy is in recession. Therefore, as with growth in the economy as a whole, growing exports will lead to higher investment and vice versa.

Government policy_ – _Government can influence the level of investment in a number of ways:

  1. Support for small businesses, such as underwriting (guaranteeing) bank loans to businesses. This increases access to finance of smaller firms, as banks are more willing to lend
  2. Tax changes, especially to profits. A reduction in the rate of corporation tax (the tax on company profits) is likely to lead to more investment, as it will earn a higher return. An increase in the tax allowance for depreciation will also encourage investment

Investment, figure 2

Changes in planning laws to make it easier for companies to get permission to develop sites for industrial use.

In country A the capital/output ratio is 4. The cost of a machine is £10,000. How many additional machines will firms need to meet an increase in demand from customers of £100,000 per year?
If gross investment in a country is £800m in a year, and net investment is -£100m, what is the value of depreciation? (in millions)
Your answer should include: 900 / 900000000