AS Macro Revision: Investment Spending

This revision blog looks at the drivers of capital spending and the importance of investment for economic performance

Data from Timetric.

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Bank of England Target 2.0 from Timetric

Different Types of Investment

Capital investment is spending by private sector businesses and also the public sector on capital goods such as new machinery, buildings and technology so that the economy can produce more consumer goods in the future.

A broader definition of investment includes spending on improving the human capital of the workforce through training and education to improve the skills and competences of workers.

Infrastructure is spending on new sewers, wind farms, telecommunications networks, airports, motorways and ports – this can be done by the private and the public sector. Many emerging market countries have invested heavily in new infrastructure as a way of expanding their productive capacity

Most economists agree that capital investment is vital to promoting long-run growth through improvements in productivity and capacity, shown for example by an outward shift in the production possibility frontier or an outward movement of the long run aggregate supply curve.

Gross and Net Investment

Gross investment spending is the total amount that the economy spends on new capital. But this figure includes an estimate for the value capital depreciation since some investment is needed each year just to replace technologically obsolete or worn out plant and machinery. If gross investment is higher than depreciation, then net investment will be positive and this means that businesses will have a higher productive capacity and can meet a higher level of AD in the future.

Investment and economic growth

In most theories of growth and competitiveness, investment has an important role to play. In this section we look at some of the major advantages from the accumulation of a bigger stock of capital.

Businesses often invest in new capital goods to exploit economies of large scale production. This, together with technological advances is vital to improving the UK’s competitiveness and to causing a shift in the country’s production possibility frontier.

Investment and Aggregate Demand

Investment is a component of AD i.e. (C+I+G+X-M). Businesses involved in developing, manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit from increased orders for new plant and machinery.

A rise in capital spending will therefore have important effects on both the demand and supply-side – including a positive multiplier effect on national income.

(i) Demand side effects: Increase spending on capital goods – affects industries that manufacture the technology / computer hardware / businesses involved in the construction sector

(ii) Supply side effects: Investment is linked to higher productivity, an expansion of a country’s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) – and therefore a source of an increase in LRAS (trend growth)

Quality of investment

A high level of investment on its own may not be sufficient to create an increase in LRAS since workers need to be trained to work the new machinery and there may be time lags between new capital spending and the knock-on effects on output and productivity in particular. Also, if there is insufficient demand, a growing capital stock may lead to excess capacity putting downward pressure on prices and profits

Investment and jobs

There are some investment projects that cost people their jobs – this is particularly true when a business is looking to achieve greater efficiency and cost savings perhaps by replacing labour with capital inputs. That said most new investment creates fresh demand for workers, both in producing, designing and installing new plant and equipment and in working with it. And if the investment is successful in creating extra demand, so the demand for labour will expand.

Investment in the UK during the recession, Key reasons for this include the following:

1. Sharply weakening demand – the result of a slump in domestic and external demand
2. Rising levels of spare capacity – falling demand means less capacity is being fully used
3. Worsening cash flows – many businesses are struggling to generate cash as demand tails away, they have less spare funds available for investment
4. Tight credit conditions – lines of funding for investment have frozen or become more expensive because of the credit crunch
5. Deteriorating profitability – the recession has cut profit margins especially for manufacturing businesses and for those involved in retailing and the building industry
6. There has been a fall in business confidence - economists refer to this as a worsening of animal spirirs.

Key revision terms:
*Business confidence: Expectations about the future of the economy – vital in business decisions about how much to spend on new capital goods
*Capital depreciation: The fall in the value of capital goods due to age and wear and tear
*Capital stock: The value of the total stock of capital inputs in the economy
*Capital-labour substitution: Replacing workers with machines in a bid to increase efficiency
*Net investment: Gross investment minus an estimate for capital depreciation