Determinants of Investment

Investment is a critical component of aggregate demand (AD). Changes in investment can shift AD:

Increase in Investment: Shifts AD right
Decrease in Investment: Shifts AD left

In economics, investment refers to firms spending money on capital goods to boost productive capacity.

Factors Influencing Investment

Interest Rates

Borrowing: Firms may borrow money to finance investment.
- Low Interest Rates: Lower cost of borrowing → higher incentive to invest → AD shifts right
- High Interest Rates: Higher cost of borrowing → lower incentive to invest → AD shifts left
Retained Profits: Using profits retained by the firm for investment.
Hurdle Rate: Required rate of return for investment projects to proceed.
- Lower interest rates make it easier to meet the hurdle rate which increases investment.

Business Confidence

Determined by:
- Expectation of Future Profit
- Expectation of Future Demand
High Business Confidence: Increases marginal propensity to invest.
Low Business Confidence: Decreases marginal propensity to invest.

Corporation Tax

Retained Profit: Profit after corporation tax.
Lower Corporation Tax: Higher retained profits → increased potential for investment.
Higher Corporation Tax: Lower retained profits → decreased potential for investment.

Spare Capacity

High Spare Capacity: Less need to invest as existing capacity can meet demand.
Low Spare Capacity: Higher incentive to invest to increase capacity.

Level of Competition

High Competition: Firms more likely to invest to overcome competitors.

Price of Capital Machinery

Lower Price of Capital: Reduces cost of investment → higher propensity to invest.

Accelerator Effect

When the rate of real GDP in the economy is increasing, it encourages more investment.
This furthers economic growth and can create a positive feedback loop.

Conclusion

Understanding these determinants is crucial for predicting changes in investment and aggregate demand. Stay tuned for the next session where we will discuss government spending.