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Consumption (C), investment (I), government spending (G-T) and net export (X-I) are the major components of aggregate demand (Y). Economists have been particularly interested in the volatility of investment.
Both Fig.1and suggest that there is a general positive relationship between GDP and investment, more importantly, investment is much more volatile. E.g. in the 10-1 recession, investment spending declined more than 10 percent while consumption spending declined only 0.6 percent.
Before trying to explain the reason(s), one should understand the nature of investment. An economy¡¯s resources can either be consumed immediately, or added to the fixed capital stock in order to use at a later date. Investment is referred to as the production and purchase of capital goods, i.e. man-made means of productions such as machinery and factories. It is an important determinants of economic growth, thus its volatility matters a lot.
One of the common theories is the concept of ¡°accelerator¡± principle, which states that small changes in consumer spending can cause big percentage changes in investment. For example, it takes $1000 worth of equipment to manufacture $1000 worth of shoes each year, i.e. assume that the ratio of capital to output (v) remains constant, equals to 1. Suppose depreciation rate is 10%, i.e. annual investment is $100. Now suppose sales jump by 5% to $1050, in order to meet this new level of demand, investment has to increase to $150, i.e. increase by 50%. And the theory can be formulated as
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It = Kt - Kt-1 = v(Yt - Yt-1)1
However, one crucial assumption in this scenario is ¡°full¡± utilization of capital (K), against which many argued. Since if there is spare capacity then a rise in output (Yt - Yt-1) can be met with existing capital stock, without new investment. Also, v is assumed to be constant, which has become less and less plausible because of technological changes. And finally, firms¡¯ investment decisions take demand changes into account, especially when they are expected to be permanent.
Although accelerator principle does have loopholes, still it applied both to fixed investment and inventories, is one aspect of business-cycle theory that is still alive today. Afterall, investment is a small component of aggregate demand, but with significant effect on economic growth, therefore the volatility can still be partly explained here.
A more complicated approach links investment and AD through profit. Here the relations between investment and profit, also profit and GDP need to be explained.
Normally people consider expected profit to be a major determinants in firms¡¯ investment decisions, since, investment should not be carried out if the return in future at discounted value is less than the costs. However, there is also evidence to believe current profit plays an important role as well. In UK and many other countries, traditional method of financing investment has been through retained profit. Also, current profit may influence firms¡¯ expectations about future profit, and a fall in current profit could lead to a belief that they will remain low for some years to come. Many firms are risk averse and not always profitable, thus they may be unwilling and unable to borrow from external sources due to above reasons, and decide to cut back on investment until the economy picks up again.
As can be seen, there is a very close link between investment and current profit.
As for profit and GDP, profits have the status of being ¡°residual income¡±, by which it means that they constitute the surplus available from total income when all other production factors have been paid. Other factors such as wage and rent have priority of income generated, while profit simply takes whatever is left. During a recession, total revenue of companies fall in line, however, firms are committed to the payment according to contracts, thus profit has to absorb the fall in revenue. Whereas in a boom, profits absorb the total increase in revenue, i.e. rise more than proportionally, since the costs of other factors are relatively fixed.
Since profit is closely related to investment, and more volatile than the business cycle, it is reasonably to say that investment is more volatile. After calculating the two relations and put them together, empirical evidence supports the theory a 1% fall in GDP will produce a fall in investment of just less than %.
Investment is influenced by many other factors apart from current/expected demand and profit; expected interest rate is one of them, because this adversely affects expected profit level when discounting for present value of a project. High current interest rate discourage firms to borrow. Also price (current and expected) of the product which affects future revenue generated by investment.
To conclude, investment is volatile since it occupies relatively a small part of aggregate demand, minor impact of GDP can have much larger impact on investment. As can be seen, investment is interrelated to many other economic variables, and can be often affected.
Some suggest as industrial production shifts away from strongly cyclical industries such as manufacturing, where the investment is highly costly and is business¡¯ major concern, the strength of cycles in business fixed investment may weaken. ¡°This moderating process is also likely to be helped by the shift toward less durable investments requiring shorter planning and construction periods, such as computers.¡±
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