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Investment involves the acquisition of capital goods designed to provide us with consumer goods and services in the future. Investment, whether by the public or private sector involves a decision to postpone consumption and to accumulate capital which can lift an economy’s productive potential. Investment is an important albeit volatile component of aggregate demand and capital expenditure has important effects on both the demand-side and the supply-side of any economy. Net and gross investment • Net investment = gross investment minus an estimate for replacement investment required to replace obsolete capital. The level of net investment in any one year tells us what is happening to the stock of fixed capital available for production. Gross fixed investment is spending on fixed assets including new buildings, plant and machinery and vehicles.
Factors that affect investment demand Expectations – the key to understanding investment decisions ‘The central message of economic theory and the evidence from business surveys is that capital investment is determined by the relationship between the expected returns from investment and the expected cost of financing the investment.’ Source: DTI Economics Research Paper on competitiveness and investment Profit-seeking businesses will be prepared to go ahead with an investment if they believe that the project will - over its projected lifetime - yield a real rate of return greater than if the money had been invested in the next best alternative way. Opportunity cost is a useful idea to use here. Private sector businesses usually focus on these objectives when investing in new capital inputs: 1. Improving productivity / efficiency as a way of driving down unit costs and achieving economies of scale 2. Investing in capital that embodies the most recent technological improvements 3. Expanding capacity to meet rising actual demand and to supply to new markets (e.g. exports) 4. Increasing capacity in advance of an expected increase in market demand 5. Replacing obsolete capital equipment and buildings For government sector investment such as new roads, schools and prisons, the priorities may be subtly different. Public sector capital projects are still subject to tests about their expected rates of return and the cost-benefit analysis will include estimates of the social costs and benefits of the investment rather than a narrow focus on private costs and benefits.
Similarly. the exchange rate and incomes.g.Value of UK Capital Investment Spending Quarterly value of capital spending at constant 2003 prices. • • • billions . higher interest rates) require greater returns from the investment to ensure that it is profitable. A rise in demand will increase the revenue streams that a business can expect from a new project. a change in the costs of purchasing the capital inputs the costs of training workers to use new capital and in maintaining the capital stock will also impact on the expected rate of return. The rate of return from an investment is also influenced by the rate at which a new capital project depreciates over time and the effects of changes in corporation tax on profits. as higher costs of finance (e. Few businesses would have predicted the impact of the credit crunch and just how quickly the supply of credit would dry up for thousands of businesses needing fresh funding for capital projects. The cost and availability of finance is important. There is always uncertainty about the expected rate of return particularly when market demand is volatile and sensitive to changes in interest rates. £ billion 65 65 60 60 55 55 GBP (billions) 50 50 45 45 40 40 35 35 30 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 30 Source: UK Statistics Commission Returns to an investment project The expected returns from capital investment are determined by the demand for and the price of the output generated by an investment and also by the costs of production. The importance of business expectations and uncertainty • One of the important lessons of Keynesian economics is the crucial role by business confidence or ‘animal spirits’ in determining how much firms are willing to commit to capital spending.
e. R2) the cost of borrowing money to finance the investment is lower and the opportunity cost of using retained profits as a source of investment finance is reduced. A fall in interest rates should (ceteris paribus) lead to an .CBI Trends Survey .Factors limiting capital spending Quarterly survey evidence. then a profit maximising business is unlikely to go ahead with a project – note the importance of expectations in determining the likely returns and costs of a project R1 R2 Investment Demand (MEC) I3 I1 I2 Planned Capital Investment (Id) The marginal efficiency of capital (MEC) is defined as the rate of interest. percentage of respondents 70 Uncertainty about demand 70 60 60 50 50 Net balance 40 Inadequate profitability 40 30 Shortage of internal finance 30 20 Inability to raise external finance 20 10 10 0 02 03 04 05 06 07 08 09 10 0 Source: CBI Manufacturing Survey The marginal efficiency of capital (MEC) – the demand curve for investment Real Interest Rate R3 If the rate of interest (r) is less than the expected rate of return on an investment. which makes a proposed investment project viable “at the margin”. At lower rates of interest (i.
Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled. For example if demand in a given year rises by £4 million and each extra £1 of output requires an average of £3 of capital inputs to produce this output. For the UK economy. or a fall in the tax on company profits.’ .expansion along the investment demand curve. then the net level of investment required will be £12 million. That said the rate of interest can and does affect capital investment decisions – perhaps through its effect on confidence and also expectations of changing demand and the links between interest rates and the exchange rate. This boost in demand and output is said to bring about a positive ‘accelerator effect. R1 MEC1 I1 I2 MEC2 Planned Capital Investment (Id) We turn to the relationship between demand. The reverse effect would be seen in an economic downturn. expectations of higher future demand. the recent evidence suggests that the demand for new capital goods is interest inelastic. Real Interest Rate An outward shift of the marginal efficiency of capital curve represents an increase in demand for investment goods at each rate of interest. The accelerator model works on the basis of a fixed capital to output ratio. A rise in output or a fall in interest rates may prompt increased levels of investment as firms adjust to reach the new optimal capital stock level. capacity and investment as we discuss the basics of the accelerator model of investment: The Accelerator Model The accelerator model suggests a positive relationship between investment and the rate of growth of demand or output. Accelerator theories assume that for a business there is a desired capital stock for a given level of output and interest rates. It might be caused by an improvement in business confidence. Partly this is because many firms prefer to use the capital market through the issue of new shares and bonds to raise funds for investment rather than relying on bank loans. Consider the diagram above that shows an outward shift of the AD curve that then causes an expansion of short run production higher profits and prompts an increase in planned investment at each rate of interest.
Keep in mind that many businesses have a large fixed cost component such as the overhead costs of operating a network. we expect to see a fall in planned investment and this is exactly what has happened. For example in the latter stages of a recession. If demand then picks up in the recovery phase of the cycle.Inflation Rate of Interest (%) SRAS R% AD3 AD2 ID2 AD1 ID Y1 Y2 Y3 I1 I2 Planned investment spending Real National Income One criticism of this simple accelerator model is that the capital stock of a business can rarely be adjusted immediately to its desired level because of ‘adjustment costs’ and ‘time lags’. notice how low the figure was during the boom of the late 1980s. That pressure on profit margins comes not just from weaker revenues. the average fixed costs of production increase . Thus when output is contracting. by the summer of 2009 over three-quarters of industrial sector businesses were reported as working below their capacity. As the scale of spare capacity increases. The adjustment costs include the cost of lost business due to installation of new equipment or the financial cost of re-training workers. the fall in demand has lowered capacity utilisation and put a big squeeze on profits. Investment spending is likely to pick up strongly towards the latter stages of a cycle – the risk being that fresh supply becomes available just at the time when demand is tailing off. Firms will usually make progress towards achieving an optimum capital stock rather than moving smoothly from one optimal size of plant and machinery to another. most businesses are operating well below their capacity limits. The data series is cyclical. From container ships to hotels and from steel plants to airlines. The time lags might be caused by supply-bottlenecks in industries that manufacture buildings and items of capital equipment. they can make more intensive use of existing capacity. In contrast. Capacity utilisation and investment The chart above shows the percentage of industrial firms operating below full capacity. A further criticism of the basic accelerator model is that it ignores the spare capacity that a business might have at their disposal.
One of the interesting features of the most recent downturn is that corporate profitability has been resilient in the face of a contracting economy. millions . the cost of financing for many borrowers has dipped compared to 207-08 (2) Quick action to control costs . These profits provide a useful cushion for a fragile business sector as we step tentatively into the recovery.0 12.000 per day in March 2009. They have kept their export prices unchanged and simply taken a better margin on each sale.5 Service Sector Industries 15.5 15.5 10.5 10. The monthly number of redundancies soared reaching over 10.0 2 0 -2 -4 -6 20.Business profitability Business profits play an important role in allocating resources – for example.0 Rate of return (%) (millions) 17. while this is largely irrelevant to those businesses paying a hefty premium above the base rate.0 17.0 12.0 99 00 01 02 03 04 05 06 07 08 09 10 Source: CBI Manufacturing Survey Manufacturing industry has suffered a profits squeeze in recent years and profitability is volatile because of big shifts in commodity prices and exchange rates Has the recession damaged the profits of UK businesses? In previous recessions in Britain.policy interest rates have been slashed to less than one per cent and. Yes there have been many high profile causalities notably in retailing and financial services. higher profits provide the funds for capital investment and also for research and development projects.many businesses were quick off the mark in reducing inventories of finished products. But the overall picture is that profits have stayed quite high. And they recover during phases of stronger economic growth Business Profits and the Economic Cycle Real GDP Growth (Top) and Net rate of return on capital employed (Bottom) 4 % change in GDP 4 2 0 -2 -4 -6 20.5 5. Profits tend to follow a cyclical pattern – they fall during a recession or an economic slowdown. raw materials and semi-finished goods once it became clear that this recession would bite hard.5 5. There are appear to be several reasons (1) Lower interest rates .0 Manufacturing 7. the profits of businesses large and small have taken a big hit and have contributed to damaging cut-backs in employment. (3) A cheaper pound: The twenty per cent depreciation of sterling against most major currencies has given export businesses an opportunity to widen their profit margins.0 7.