"Investment is always likely to be more volatile than other elements of "Investment is always likely

University Degree Business and Administrative studies

“Investment is always likely to be more volatile than other elements of “Investment is always likely

The volatility of the level of investment is one of the most repeatedly observed features of most economies. Although the fluctuations of an economy over time affect all of the variables that are used by economists to show the current state of prosperity (for example national income, production, employment, prices, etc.), the level of investment has been noted for being particularly volatile. In discussing whether this will always be the case, various hypotheses and theorems regarding the behaviour of investment and its relationship to other elements of the economy will have to be considered.

The first problem that has to be surmounted is the issue regarding what investment actually is. An economy’s resources can either be consumed immediately (consumption), or added to the fixed capital stock in order to use at a later date. This is a basic definition of investment. It is worth noting in passing that both consumption and investment form part of aggregate demand. The level of investment in an economy is usually defined as the expenditure on fixed assets for either replacing old equipment or adding to stock. This is known as “Gross Domestic Fixed Capital Formation” (GDFCF). Unfortunately, the composition of GDFCF is somewhat arbitrary in practice as only investment in the business sector of the economy is considered. The general cause for concern regarding this is the example of the same product being purchased for use at home and for business. In the former example, it will not count as part of GDFCF, but if the owner is self-employed and intends to use it for business, it will count as investment. The rationale appears to be that a business will utilise the product to contribute more output to the economy.

GDFCF is, however, a gross calculation, which means that it neither takes into account the fact that some capital goods are purchased in order to replace others, nor are the affects of depreciation considered. Although net investment would in theory take account of these issues, there are many practical difficulties regarding the obtaining of the relevant data, thus rendering the process too complicated and difficult to undergo. Thus, the gross form of the data is used, albeit with its inherent defects knowingly recognised.

The volatility of the level of investment in recent times can be shown by the fact ...

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The volatility of the level of investment in recent times can be shown by the fact that gross investment in the UK economy was £128billion in 1999, which was £45billion higher than in 1979. Moreover, the level of gross investment plummeted in the recessions of the early 1980s and 1990s, and soared during the Lawson boom years of the mid-1980s.

One of most common theories used to explain the volatility of the level of investment is known as the “accelerator” principle. This relates net investment to the rate of the change in output. Assuming that all capital resources are fully utilized, and there is a constant ratio of capital to output (v), the increase in net investment (I), can be calculated by the following formula:

I=v*(change in Y).

Thus, if output rises by £5 million, and every pound of output requires £2 of capital to produce it (v = 2), then the increase in the level of extra investment required would be £10 million. On its own, though, this merely shows that if output falls, investment will fall proportionally with it, and vice-versa. It does not explain why investment is always likely to be more volatile then other components of the economy. It has been suggested that there are “buffers” in the economy which prevent further growth. For example, if full employment (or the maximum possible employment rate) is reached, then it is impossible for any more labour or capital to be employed, thus causing investment to fall as output cannot grow above this level. This suggestion also works in the converse manner too: there is a certain theoretical baseline below which demand or output cannot fall, thus investment will not drop below this point either. The buffer theory allows an explanation why consumption is less volatile than investment. As the former is based on income, it is going to be affected by the investment which produces the income. For income levels to remain high, the level of investment must be high, and investment can only stay at this level if incomes are rising.

Although this theory seems a plausible explanation, it has also been suggested that if the change in investment is time-lagged, to reflect the fact that any decision to invest cannot be translated into actions immediately, and that the level of current demand has to be considered. This version of the accelerator model displays likeliness to over- or undershoot as firms try to adjust their investment level to match demand. The formula for the accelerator is much the same in the most basic form of this model, but the level of investment is for t+1.

That this time-lagged model seems more likely than the buffer model is mainly due to the fact that most firms are likely to make their investment decisions based on the current demand level, or the demand level in the recent past. If demand were to suddenly fall, firms will have to store any excess output as inventory, and if it were to rise, it could be quickly met by the emptying of these stores before any extra investment decision is taken.

This idea that investment decisions are made on account of expected returns was also suggested by Keynes, who felt that any investment decision had to be made in relation to the cost of foregoing consumption. He suggested that this could be formulated as the marginal efficiency of investment (MEI), which reflects the effect of interest rates on the present value (PV) of the money to be invested over time. It can be plotted on a curve (figure one) which is negatively sloped as the earliest investment undertaken is likely to have the highest MEI making it the most profitable (offering the largest annual returns). The more that is invested, the smaller the level of returns, and thus the lower the MEI. A rise in investment may increase the supply price of the good to be invested in, which will reduce the MEI, due to, for example, existing capacity constraints. If the interest rate is smaller than the MEI, the project will be profitable. At interest rate r on figure one, all projects up to investment level I are likely to be profitable. However, this model excludes the possibility of fluctuations in demand, which will shift the MEI curve to the left or to the right. Even so, a fall in interest rates are likely to shift the MEI curve to the right, thus raising expected returns. Most studies, though, suggest that the investment level is either interest-inelastic (for example Savage’s work in this field) or only weakly connected to the interest rate (Whittaker). Having said this, Oslar looked at the relationship in not only the UK, but also France, Japan, Canada, and Germany, noting that the high levels of interest rates in these countries between 1990 and 1993 depressed investment and reduced output by between 2.5% and 4.5% per year. The increased volatility of investment compared to other elements of national expenditure may indeed be partly explained due to the effects of interest rates, as companies are more likely to invest if returns are to be high, but this conclusion could be reached in other ways.

Research by Ford and Poret suggested that firms revise their intended levels of investment by a smaller amount during times of economic stability than in periods of uncertainty. This would suggest that the volatility of investment is more likely to be caused by the economic cycle, rather than be a cause of it. In periods of uncertainty, it is likely to be very hard to predict just when the upswing will begin. Firms will therefore be less willing to invest, due to the expectations of lower returns and lower customer demand, thus the level of investment will fall.

Investment is therefore likely to be more volatile than other components of national expenditure, because not only does it provide income and thus allow for further expansion, the level of investment will depend on current demand and expectations of future demand. Unexpected shocks, like a hike in oil prices, are therefore likely to be amplified by the drop in the level of investment more than the effects on prices or consumer demand, because firms will have to drastically readjust their investment decisions.