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Identify the key factors that determine the level of investment in a modern economy and comment on the view that the accelerator model of investment is too limited to offer a full explanation

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Introduction

Identify the key factors that determine the level of investment in a modern economy and comment on the view that the accelerator model of investment is too limited to offer a full explanation The term 'investment' in economics refers to the use of capital to create productive facilities such as plant and equipment, buildings and so on. It can also refer to expenditure on 'human capital', that is, investment on education and training as an investment in the quality of the labour force. Total investment includes spending by firms and Government on all types of capital goods and makes up about one-fifth of total spending in an economy. Investment inevitably requires a sacrifice. Usually the sacrifice is reduced consumer expenditure in order to free capital resources for investment today so that output can be higher tomorrow. ...read more.

Middle

Business expectations could be crucial; investment opportunities (such as a major new innovation) will have an important effect; the availability of investment funds could be significant; and rising income levels and/or profits will also have an impact on aggregate investment. Finally, changes in Government policy with respect to investment in the infrastructure, housing or state industries will affect overall investment levels in the economy. The accelerator theory has been used to elaborate on the link between investment and rising income as noted above. The theory suggests that the current net level of investment will depend on past changes in income in the economy. Put simply, It = v (Yt - Yt-1) : where It is net investment in the current time period and Yt - Yt-1 is the change in income over the last time period. ...read more.

Conclusion

The theory can be challenged on the grounds that it is too limited to accurately explain investment behaviour. First, it assumes that, just because firm's experience rising demand for their output, they will automatically start to increase their capital stock. This is very unrealistic and completely neglects the fact that there may be substantial under-utilisation of plant and equipment at present. Secondly, the model ignores the important role of business expectations. If a surge in product demand is seen as being only short term, the entrepreneur may not respond by increasing the capital stock. On the other hand, if there are signs a major upswing in the economy in the near future, the firm may invest far more heavily now than it would have done by simply following the accelerator model. In conclusion, it should be noted that empirical studies of investment usually include the rate of interest, past changes in national income and business expectations as the main explanatory variables. By Afzal Yearoo ...read more.

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