Definition and Distinction

Investment: Spending by firms on capital goods, such as machinery, factories, and technology, in order to increase future productive capacity.

Gross Investment: Total spending on new capital plus the replacement of worn-out or depreciated capital.

Net Investment: Gross investment minus depreciation, which is capital consumption. This shows the net addition to the capital stock and is what matters for increasing an economy's productive potential.

Key Influences on Investment

Investment is a volatile component of aggregate demand and is strongly influenced by business confidence and expected rates of return.

The Rate of Economic Growth

• High and rising growth through the accelerator effect signals strong future demand and encourages firms to invest in new capacity.
• Low or negative growth discourages investment because demand is weak and firms may already have spare capacity.

Interest Rates and the Cost of Capital

• Higher interest rates increase the cost of borrowing to finance investment.
• They increase the opportunity cost of using retained profits, because those funds could earn interest if saved.
• They reduce the Net Present Value (NPV) of future investment projects, making them less attractive.
• Lower interest rates tend to have the opposite effect and stimulate investment.

Business Confidence and Animal Spirits

Confidence in future profits, political stability, and the wider economic outlook is a major influence on investment.

Keynes' animal spirits refers to the herd-like optimism or pessimism of investors, which can make investment fluctuate sharply even when interest rates do not change much.

Government Policy and Regulation

Incentives: Subsidies, tax breaks such as investment allowances, and better infrastructure can encourage investment.

Disincentives: High corporation tax, excessive regulation, or political uncertainty can reduce investment.

Access to Credit

• Even if interest rates are low, a credit crunch can restrict investment if banks are unwilling to lend.
• This can be especially important for smaller firms.

Impact of Investment

Short run: Investment increases aggregate demand.

Long run: Investment increases the economy's productive potential and can shift long-run aggregate supply (LRAS) to the right, supporting non-inflationary economic growth.

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