Unit 2 Macro: Revision on Capital Investment

Here is a planned answer to an exam question

“Explain two factors that are likely to affect the level of aggregate investment.”

An explanation question does not require evaluation, instead define your terms, select two relevant factors and explain them clearly using supporting examples or evidence to improve the quality of your answer

Definition: Investment is spending on capital goods such as new factories & other buildings machinery & vehicles. 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.

Factors affecting investment:

For the question choose two and develop them using clear chains of reasoning: (I have provided four below to aid the revision!)

Interest rates:

Interest rates affect the cost of borrowing money to finance investment. If the rate of interest increases, the cost of funding investment increases, lowering the expected rate of return on a capital project. Higher interest rates also raise the opportunity cost of using profits to finance investment – i.e. a business might decide that they can earn a better return by simply investing the cash.

The rate of growth of demand:
Investment tends to be stronger when consumer spending is rising. Higher expected sales also increase potential profits – in other words, the price mechanism should allocate extra funds and factor inputs towards capital goods into those markets where consumer demand is rising. In a recession, demand is weaker and many businesses find they are operating with higher levels of spare capacity, investment will fall as a result. Indeed in the last UK recession, the real level of capital spending fell by more than 25%.

Corporate taxes

Corporation tax is paid depending on the level of business profits. If the government reduces the rate of corporation tax there is a greater incentive to invest.
Other government policies may affect the level of investment – for example tax relief on capital spending by smaller businesses and financial support for investment in economically-deprived regions.

Business confidence (animal spirits)

When confidence is strong then planned investment will rise. In contrast, during a downturn many businesses may opt to postpone investment because they feel that demand will not be high enough to give them the rate of profit they need.Committing money to an investment project involves taking a risk for no business can be certain that a given project will succeed and bring about a profit. When risk and uncertainty is high for example during times of economic volatility then business investment spending may fall.