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. Investment is the most volatile element of national expenditure and changes in this important variable generate, in turn, multiplier effects on the rest of the economy. It is, perhaps, the single most crucial element in determining the success of the economy and cyclical instability and economic growth are thought to be closely related correlated with the trends in investment expenditure.

First, a firm that plans to invest must assess the cost of capital (mainly the interest rate) and compare it with the expected return on the investment. If expected yield exceeds cost, the investment project may proceed. Since machines and factories generate that yield over time, it is necessary to calculate the present value of future flows of revenue in order to produce a fair comparison. In effect, in assessing the rate of return on additional investment projects, the firm is determining the marginal efficiency of capital.

Investment will also depend on several other factors. Business expectations could be crucial; ...

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Investment will also depend on several other factors. 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. The term ‘v’ is the accelerator coefficient which is a constant.

More complex and sophisticated accelerator models can be developed using different time lags between a change in income and a change in investment. Whichever version of the accelerator model is employed, its accuracy depends upon whether firms behave in a particular way, in turn, this means that the accelerator theory depends on three crucial conditions being met in practice. First, if net investment is to remain positive at a constant level, the firm must be experiencing a consistently steady increase over time in the demand for its product. Otherwise, if the rate of increase in declines, investment behaviour will also adjust until eventually there is no need for further additions to the capital stock. Secondly, if net investment is to go on rising over time, the demand for the firm’s product must also be increasing at a faster rate. Finally, the implications of the theory suggest that if demand levels off and stays constant, net investment will eventually decline to 0.

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.