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A2 Macroeconomics / International Economy

Capital Investment & Spending

In this note we consider the Keynesian theory of investment and look at some of the evidence on business investment spending in the UK economy.

The meaning of investment to an economist
Investment to an economist is a precise term which involves the acquisition of capital goods designed to provide us with consumer goods and services in the future. Investment spending involves a decision to postpone consumption and to seek to accumulate capital which can raise the productive potential of an economy. But investment is similar to consumption as it is an important component of aggregate demand.

It is important to remember that investment has important effects on both the demand-side and the supply-side of the economy.

Net and gross investment

• Net investment in any given year = gross investment minus an estimate for replacement investment – i.e. that investment required to replace obsolete capital. The level of net investment in any one year tells us what is happening to the final stock of fixed capital available for production.
• Gross fixed investment is spending on fixed assets. The biggest single item of investment spending is on new buildings, plant and machinery and vehicles. The real value of business investment in the UK economy over recent years is shown in the next data chart.

Autonomous and induced investment

• Autonomous investment is capital expenditure on producer goods unrelated to the level of national income. For example, the cost of purchasing new items of capital equipment would affect autonomous investment.
• Induced investment is related to levels of national income. An increase in GDP increases induced investment but leaves autonomous investment unaffected. The accelerator theory of investment which we will consider shortly is an example of this.

Factors that affect investment demand
As with consumption and saving, we find that there are plenty of theories as to the main factors driving investment decisions in the economy. For example, a detailed survey of these theories published by the UK Treasury in June 2003 argued that:

In other words, profit-seeking businesses operating in the private sector of the economy will be prepared to go ahead with an investment if they believe that the project will over its projected lifetime yield a real rate of return greater than if the money tied up in an investment project had been invested in the next best alternative way.

Efficiency improvements seem to dominate the investment aims of industrial businesses

For government sector investment, the priorities may be a little different. Public sector investment projects are still subject to tests about their expected rates of return, but the cost-benefit analysis will normally also include estimates of the social costs and benefits of the investment rather than a narrow focus on private costs and benefits.

Between the years 1997-2005, the real level of gross investment spending in the UK increased by 40% although, when measured as a share of national income, total investment remained fairly static at just under 17%. This is similar to that of the United States but much lower than countries such as Japan and China where investment in recent years has run at a staggering rate of over 40% of her national income! Indeed the Chinese government has sought recently to bring this level of investment down because of fears that the economy is “over-investing”, risking creating too much capacity and also raising fears that much of the super-charged investment has been of fairly low quality and financed by risky lending.

The bulk of capital investment in the UK economy is done by service sector businesses, hardly surprising when services account for over seventy per cent of our GDP. Worryingly, manufacturing investment as a share of GDP has been falling steadily over the last decade and reached its lowest ever level in 2004 and 2005. Government investment has been picking up, but again from low levels.

Business investment has risen as the economy has expanded – but has it increased quickly enough?

The majority of capital investment spending is done by the private sector, although there has been a sizeable increase in government investment in recent years because of infrastructural projects in transport and the NHS building programme. Because of the dominance of the private sector, it makes sense to focus on investment decisions made by UK-based businesses. At the heart of whether or not to go ahead with a project is the expected return from this investment.

Returns to an investment project

The expected returns from capital investment are determined by the demand for and the price of the output of goods or services generated by an investment and also by the costs of production. A rise in demand for the output that capital is purchased to supply 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

Expectations of demand, prices and costs over the lifetime of the investment are key determinants of expected returns. 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 an investment project is assumed to depreciate over time and the effects of changes in corporation tax on company profits.

The cost and availability of internal and external 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.

The marginal efficiency of capital (MEC) – the demand curve for investment

Expected rates of return on investment matter when businesses are making investment decisions and this is where the concept of the marginal efficiency of capital comes in. The marginal efficiency of capital (MEC) is defined as the rate of interest which makes a proposed investment project viable “at the margin”. This is illustrated in the diagram above. At lower rates of interest (i.e. R2 rather than R1) more capital projects appear financially viable because the cost of borrowing money to finance the investment is lower and the opportunity cost of using retained profits as an internal source of investment finance is also reduced. A fall in interest rates should (ceteris paribus) lead to an expansion along the investment demand curve. Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled.

The limited statistical evidence available for the UK is that the demand for new capital goods tends to be interest inelastic i.e. there is only a weak link between changes in interest rates and fluctuations in planned capital investment by businesses. Partly this is because many firms prefer to use the capital market through the issue of new shares and bonds to raise funds for investment rather than relying on bank loans.

That said, the rate of interest can and does affect capital investment decisions – perhaps through its effect on business confidence and also expectations of changing demand and the links between interest rates and the exchange rate. So a period of lower interest rates might stimulate more investment because of expectations of rising consumer demand and a lower exchange rate which will boost export demand.

Changes in business confidence, the costs of capital and demand lead to shifts in the investment demand curve. For example, an increase in export sales overseas might be an increase in the expected rates of return on capital investment and thus an outward shift of the investment demand schedule.

Concerns about demand and profits act as constraint on investment plans

The data shown in the previous chart is taken from the quarterly survey of business confidence by the Confederation of British Industry. It suggests that uncertainty about the strength of future demand and the absence of a satisfactory level of profit are consistently the two biggest factors likely to constrain the level of capital investment by businesses. Certainly in recent years, the cost of finance – influenced by the level of interest rates – has come firmly at the bottom of the ranking of key factors, although this may not be the case for smaller manufacturing businesses that may not have the opportunity to borrow at the same rate of interest as larger multinational operations.

The Accelerator Model of Investment

This is another theory of investment. Put simply, the accelerator model suggests a positive relationship between investment and the rate of growth of demand or output. Accelerator theories of investment assume that there is a desired capital stock for a given level of output and interest rates. A rise in output or a fall in interest rates may prompt increased levels of investment as firms adjust to reach the new optimal capital stock level.

The accelerator model works on the basis of a fixed capital to output ratio which implies that in order to produce extra goods and services a business needs to adjust its investment to meet changes in demand. For example if demand in a given year rises by £4 million and each extra £1 of output requires an average of £3 of capital inputs to produce this output, then the net level of investment required will be £12 million.

One criticism of this simple accelerator model is that the capital stock of a business can rarely be adjusted immediately to its desired level because of ‘adjustment costs’ and ‘time lags’ between an investment project being given the go-ahead and it coming ‘on stream’ to produce the extra output. The adjustment costs include the cost of lost business due to installation of new equipment or the financial cost of re-training workers. Firms will usually make progress towards achieving an optimum capital stock rather than moving smoothly from one optimal size of plant and machinery to another.

A further criticism of the basic accelerator model is that it ignores the level of spare capacity that a business might have at their disposal. For example in the latter stages of an economic recession, most businesses are operating below their capacity limits (i.e. there is a sizeable negative output gap in the economy). If demand then picks up in the recovery phase of the cycle, there is little immediate need for businesses to increase their investment because they can make more intensive use of whatever existing capacity is available now. Investment is more likely to be strong when businesses are operating close to their production limits, and when they need to boost their capacity in order to meeting rising demand from consumers.

If businesses are working below full capacity they may not need to invest in lots of new capital goods

The chart above shows the percentage of industrial firms operating below full capacity. The data series is highly cyclical; notice for example how low the figure was during the boom of the late 1980s but then shot up to over 70 per cent during the recession of the early 1990s. There is no automatic link between the level of spare capacity and planned investment because other factors will come into play when businesses are making investment decisions.

Summary of the key factors driving capital investment spending

• Interest rates: Interest rates play a role in shaping investment decisions but the demand for capital goods tends to be inelastic after changes in interest rates – at least in the short term. In other words, the marginal efficiency of capital curve can be drawn as inelastic.
• Expectations and confidence: Expectations of demand and expectations of the costs of buying and running new capital goods are an important factor in the investment decision. Thus the state of business confidence cannot be ignored in understanding investment theory. Interest rates do have an effect on these expectations.
• Profits: The level of business profitability is a major factor driving investment demand. Higher profits suggest a more favourable business climate which boosts business confidence. Higher profits also make it easier for firms to reinvest their “producer surplus” to fund capital projects.
• External economic factors: The health of the global economy is becoming an important factor influencing capital spending decisions. For example, businesses will consider where to locate their new investments – focusing on factors such as relative cost levels, corporate taxation regimes in different countries, expectations of income and demand growth in different regions and nations and the volatility of exchange rates

Business profitability
Business profits play an important role in allocating resources – for example, higher profits provide the funds for capital investment and also for research and development projects. Profits tend to follow a cyclical pattern – they fall during a recession or an economic slowdown. And they recover during phases of stronger economic growth

Manufacturing industry has suffered a profits squeeze in recent years

The chart above shows the percentage rate of return on capital – a measure of business profitability. Throughout the period shown, the profit made by service sector businesses has been higher than for manufacturing industries. Firstly, manufacturing industry in the UK has been in relative decline for many years because it faces much greater competition from lower-cost overseas producers – this decline is known as a process of deindustrialisation. This tough global competition affects the level of demand but it also means that British manufacturing businesses have less pricing power in their own markets. UK markets have become more contestable and this has dampened profit margins.

In the last few years, there has been a downward trend in business profits – the result of

• A strong exchange rate which hits the profit margins of exporters.
• Rising costs e.g. oil prices for firms that use oil as an essential input.
• Higher labour costs – including several rises in the national minimum wage
• Capital investment accounts for just under a fifth of UK national income and it is a volatile component of aggregate demand that impacts on both the demand & supply side of the economy
• Net investment = gross investment – replacement investment
• Positive net investment increases a country’s productive capacity and contributes to a faster trend rate of growth in the long run
• Firms invest to increase current supply capacity in the expectation that selling more products increases revenues and profits or leads to lower costs (economies of scale) and improvements in productivity and efficiency.
• New investment also helps to exploit new technologies and is an important factor keeping firms competitive in the global economy.
• The Marginal Efficiency of Capital is the rate of return on each extra unit of capital invested.
• Private sector businesses have an incentive to continue to invest if the returns they anticipate from each additional capital project exceed the current market rate of interest rate. Lower interest rates should lead to an expansion along the planned investment demand curve.
• Improved business confidence increases expected rates of return, shifting the MEC curve to the right.
• Any anticipated slow down or a possible recession in the economy that lowers expectations causes an inward shift in the MEC curve.
• The accelerator model predicts a positive relationship between the rate of growth of demand and planned investment. But much depends on the capital to output ratio; the amount of spare capacity that a business has, and also the supply-side capacity of businesses that produce the capital goods.