Economics: Autonomous Investment

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In this lesson, we will take a close look at investment spending. Investment spending is the spending by businesses on capital goods, goods that produce other goods. When a business builds a new factory or purchases a major piece of equipment, we count that as investment spending. We also count it as investment spending when a household builds a new house. When an economist uses the term "investment," they are almost always, however, referring to spending by businesses on capital goods. That may not be the way you use the term investment. You may use it to refer to money in your savings account, or stocks and bonds that you purchased. Be clear though, when an economist refers to investment, they are referring to spending by businesses on capital goods.
What determines the amount of investment spending in our economy in any given period? Well, businesses are making these investment decisions in hopes of increasing their profits. Anything that makes these businesses more profitable is likely to make them spend more on investments. Consider for instance, the effect of depreciation--your old equipment is wearing out. If depreciation occurs at a faster rate, businesses will be inclined to buy more replacement capital goods in any given period. Also, technological progress affects the amount of investment. Any time technological progress speeds up, your old equipment is becoming obsolete faster and businesses are likely to increase the amount of investment spending they do in any given period. Also, government policy can affect the amount of investment spending that businesses want to do. Tax credits for investment or accelerated depreciation might lead businesses to invest more in any given period. Finally, one big influence on investment spending is the interest rate. It's so important in fact that we draw a graph to show the relationship between the interest rate and the total amount of investment spending done in the economy in a given period. The interest rate is critical because businesses are usually borrowing money to undertake major investment purchases like building a new factory or buying an expensive piece of equipment. When the interest rate goes up, then it's going to be more expensive for businesses to do these investments and therefore they are less likely to do them. On the other hand, lower interest rates lower the cost of putting new factories online or bringing new equipment in and therefore businesses are more likely to make those investments.
Let's show all of this in a diagram with the interest rate on the vertical axis and the total amount of investment on the horizontal axis. We can draw a curve in this space that shows the level of investment spending as a function of the interest rate. The curve is downward sloping and here is why. Take any given point on the curve. If the interest rate goes up, it's now more expensive to do investments. And our investments right here at the margin that the business was saying, "almost, just barely profitable, we will go ahead and do them," however, when the interest rate goes up, that increased cost leads the business to drop that investment and the quantity of investment falls. Higher interest rates make investments unprofitable and therefore businesses will make fewer off them. That's why the investment curve slopes downward, drawn with respect to the interest rate.
What would cause this curve to shift? A change in any of the variables that we hold constant when we draw it, that is, anything besides the interest rate that affects the level of investment can shift this curve. For instance, if the government enacts a policy of investment tax credits and gives businesses tax breaks for making investments this year, then we would expect to see the curve shift outwards, that means there will be more investment spending by businesses at every interest rate. On the other hand if technological progress should slow down for some reason and businesses don't have to replace their equipment as often, we'd then see the curve shift inwards--a reduction in investment at every interest rate.
Let's see now how investment spending shows up in our aggregate expenditure diagram. Remember the aggregate expenditure diagram shows the relationship between income and total spending in the economy. We have already got consumption in the picture, and the consumption line slopes upwards because consumption spending increases with income. If we want to add investment to this picture, we will simply slide the curve up parallel to its original position by the amount of investment spending. We do that because investment spending is independent of income in the economy. That is, changes in income don't change the amount of investment spending, which we imagine depends on the interest rate, on government policy, on depreciation, and technological progress. Because investment spending is independent of the level of income, the shift is parallel.
Let's make one final distinction and that's between planned investment and unplanned investment. Planned investments are the plans of the business to bring new factories, equipment, and other capital goods online in their operations. Unplanned investments in our story are the accumulation of inventories that the business didn't count on. Anytime they produce goods that are not actually purchased in a given period, the business is adding to its inventory. It may plan some amount of inventory increase. However, if demand is below their projections, they might find themselves accumulating inventory that they hadn't counted on, this is unplanned investment. Unplanned investment is the component of additional inventory that the business didn't expect to add.
Finally, we are going to take a look at historical data and the key here is to notice how volatile investment spending is, far more volatile than the economy in general. The blue line in this picture shows gross domestic product and how it changes over time. The red line moving around it shows gross investment, the additional business spending brought into the economy in each period. Notice how much more the red line jumps around than the blue line. Business spending is more volatile than the economy in general. Businesses are always looking at which way the wind is blowing to project their profits, trying to imagine whether the signs are good or bad for them. And when businesses get spooked, they are likely to quickly change the level of investment. And when businesses get optimistic, they are likely to rush to tool up so they can keep up with expected demand. As a result, gross investment is a forward-looking decision and much more volatile than the economy in general.
Aggregate Expenditures Model
Components of Aggregate Expenditure
Autonomous Investment Page [1 of 2]