Revision: Importance of Business Expectations

Expectations matter hugely for businesses - and changes in business sentiment have important macroeconomic effects at different stages of the economic cycle. This brief revision note looks at the role of expectations.

Business expectations can affect

1/ The willingness to go ahead with capital investment projects

2/ Decisions over employment levels

3/ The desired level of stocks - which in turn affects short term production decisions

These are just three aspects, I am sure you can think of many more. Let us focus on the first - expectations and spending on new capital goods

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. A rise in demand will increase the potential revenue streams that a business can expect from a new project. Similarly, 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 affect the expected rate of return.

The importance of business expectations and uncertainty

• There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and incomes.

• 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.

• The cost and availability of finance is important, as higher costs of finance (e.g. higher interest rates) require greater returns from the investment to ensure that it is profitable.

Key evaluation point - uncertainty about future levels of demand is nearly always the main factor driving investment decisions - hence the risk of a negative accelerator effect during an economic slowdown or recession.