Investment can be defined as the change in the capital stock over a period of time—normally a year for accounting purposes. It is not to be confused with financial investment, which involves the purchase of financial assets, such as stocks and shares, and is, therefore, more closely connected with the analysis of saving. It is also commonly distinguished from inventory investment, which involves changes in stocks of finished goods, work in progress and raw materials.
Capital investment goods differ from consumption goods in that they yield a flow of services, over a period of time, and these services do not directly satisfy consumer wants but facilitate the production of goods and services, or consumer goods. Although some consumer goods are perishable, a large number provide services over a period of time and are, therefore, akin to investment goods. Such goods are called consumer durables. The existence of various goods that provide flows of services over time presents problems for national income accounting. This is because it is not always clear whether such goods should be classified as investment or consumer goods. Expenditure on land and dwellings, by households, is an example. In the UK such expenditures are treated as investment. Expenditure on plant and machinery is, however, clearly part of (capital) investment, since it either replaces worn-out machinery or adds to productive capacity. Gross investment is total expenditure on capital goods per year, and net investment is gross investment net of depreciation—which is the decline in the capital stock due to wear and tear.
A distinction is often drawn between public investment, which is undertaken by the public sector, and private investment. Direct foreign, or overseas, investment involves the purchase of financial or productive assets in other countries and should be distinguished from overseas portfolio investment.
A number of theories have been developed to explain the determination of investment demand. These commonly relate to private-sector investment demand, since public-sector investment may involve other considerations. The importance of investment lies in the fact that a rise in the capital stock of an economy may increase its productive capacity and potential for economic growth. It should be noted that the capital stock is one of a number of factors of production, along with labour and raw materials, which contribute to production and, therefore, that investment is not the sole determinant of growth. Additionally, investment is a major route through which technical progress can be made.
Public investment may be guided by principles other than narrow profit maximization, since the government should take account of social costs and benefits as well as pecuniary ones. Public investment might, consequently, be undertaken to alleviate unemployment in depressed areas or to encourage technical change. Keynesian economists have argued that public investment can be an important catalyst to economic development and may have a significant role to play in leading an economy out of recession.
Economic literature postulates that there are two major determinants of private investment demand: the rate of interest, and the increase in national income. Other factors clearly influence investment as well: these include wage and tax rates, which affect the relative cost of capital and labour. Assuming that these other influences are constant, however, it is postulated that changes in the rate of interest or national income will cause a change in the desired capital stock and that this will lead to investment.
A change in the rate of interest will influence the desired capital stock by altering the expected profitability of various potential investment expenditures. This can be seen in various ways. Firms may be viewed as forecasting the revenues and costs over the life of the project in which the capital good is to be employed. To do this they must forecast the expected life of the project, the sales volumes and prices and various costs, in each year of the project. The expected project life will depend on both the physical life and the technological life of the capital good. A firm will not wish to operate with obsolete capital goods, since it will be at a cost disadvantage relative to its competitors. Having estimated the expected future flow of profits, and any scrap value that capital good might have at the end of the project’s life, the firm will then discount this expected income stream. If it discounts it using the market rate of interest, then it will discover the gross present value of the project, and after subtracting the cost of the capital good it will have calculated the net present value. If this is positive, then the profit is acceptable given the risk involved and the attractiveness of alternative projects. A fall in the rate of interest will lead to a rise in the net present value of various projects and will, other things being equal, lead a number of firms to want to buy additional capital goods. In aggregate, the desired capital stock will rise. Keynes explained the influence of the interest rate on investment in a slightly different manner, based on the internal rate of return, or what he called the marginal efficiency of capital. This alternative suggests that firms will find the rate of discount which equates the (discounted) expected flow of returns to the cost of the capital good. If this rate is less than the market rate of interest, then the project is potentially profitable. A fall in the interest rate should, therefore, increase the number of potentially profitable projects and hence the aggregate desired capital stock. If a firm is borrowing funds to finance investment, the interest rate represents the cost of borrowing. If it is financing investment from internal funds, the interest rate represents the opportunity cost, since it represents the revenue the firm could, alternatively, receive from financial investment. Such explanations of the determination of investment demand are based on an assumption of fixed interest rates, throughout the life of the project. Financial institutions are, however, increasingly lending at variable rates, and this will further complicate the investment decision by requiring firms to form expectations of interest rates throughout the project’s life. It is to be noted that expectations play a major role in determining investment demand, according to this analysis, and that, consequently, a government policy of trying to stimulate investment, by reducing the interest rate, might not have the desired effect in times of worsening expectations of future profits.
A second major influence on investment demand is believed to be the change in national income. A rise in national income might increase expected sales and lead to a desire to increase productive capacity. The accelerator theory is a more formal explanation of the influence of a rise in national income on investment. It postulates a fixed ratio of capital to output, based on technological considerations, so that output growth should lead to an increase in the desired capital stock. It seems unlikely that an economy’s capital to output ratio is fixed over time, since many factors will influence this ratio, such as the relative cost of capital and labour, technical progress, and changes in the relative importance of various sectors of the economy, which may have different capital/output ratios. In its crude form the accelerator theory does not perform well empirically, but in more flexible forms it is more successful at explaining investment.
It is, therefore, clear that a change in the rate of interest or in national income might influence the demand for capital goods and change the aggregate desired capital stock for the economy as a whole. The actual net investment that occurs each year in any economy depends on the rate of depreciation of capital stock, and on the extent to which the increased demand for capital stock is satisfied. This will in turn depend on the ability of the capital goods-producing industry to meet the increased demand; the extent to which the price of capital goods rises in response to the increased demand, thus raising the cost of capital goods and reducing the net present value of investment projects; and the extent to which suitable capital goods can be purchased from abroad.
Andy Mullineux
University of Birmingham
Further reading
Hawkins, C.J. and Pearce, D.W. (1971) Capital Investment Appraisal, London.
Junankar, P.N. (1972) Investment: Theories and Evidence, London.
Maurice, R. (ed.) (1968) National Accounts Statistics: Sources and Methods, London.
