Other Determinants of Investment Demand

Perhaps the most important characteristic of the investment demand curve is not its negative slope, but rather the fact that it shifts often. Although investment certainly responds to changes in interest rates, changes in other factors appear to play a more important role in driving investment choices.

This section examines eight additional determinants of investment demand: expectations, the level of economic activity, the stock of capital, capacity utilization, the cost of capital goods, other factor costs, technological change, and public policy. A change in any of these can shift the investment demand curve.

Expectations

A change in the capital stock changes future production capacity. Therefore, plans to change the capital stock depend crucially on expectations. As expectations change in a way that increases the expected return from investment, the investment demand curve shifts to the right. Similarly, expectations of reduced profitability shift the investment demand curve to the left.

The Level of Economic Activity

Firms need capital to produce goods and services. An increase in the level of production is likely to boost demand for capital and thus lead to greater investment. Therefore, an increase in GDP is likely to shift the investment demand curve to the right.

To the extent that an increase in GDP boosts investment, the multiplier effect of an initial change in one or more components of aggregate demand will be enhanced. We have already seen that the increase in production that occurs with an initial increase in aggregate demand will increase household incomes, which will increase consumption, thus producing a further increase in aggregate demand. If the increase also induces firms to increase their investment, this multiplier effect will be even stronger.

The Stock of Capital

The quantity of capital already in use affects the level of investment in two ways. First, because most investment replaces capital that has depreciated, a greater capital stock is likely to lead to more investment; there will be more capital to replace. But second, a greater capital stock can tend to reduce investment. That is because investment occurs to adjust the stock of capital to its desired level. Given that desired level, the amount of investment needed to reach it will be lower when the current capital stock is higher.

The Cost of Capital Goods

The demand curve for investment shows the quantity of investment at each interest rate, all other things unchanged. A change in a variable held constant in drawing this curve shifts the curve. One of those variables is the cost of capital goods themselves. If, for example, the construction cost of new buildings rises, then the quantity of investment at any interest rate is likely to fall. The investment demand curve thus shifts to the left.

Other Factor Costs

Firms have a range of choices concerning how particular goods can be produced. A factory, for example, might use a sophisticated capital facility and relatively few workers, or it might use more workers and relatively less capital. The choice to use capital will be affected by the cost of the capital goods and the interest rate, but it will also be affected by the cost of labor. As labor costs rise, the demand for capital is likely to increase.

Technological Change

The implementation of new technology often requires new capital. Changes in technology can thus increase the demand for capital. Advances in computer technology have encouraged massive investments in computers. The development of fiber-optic technology for transmitting signals has stimulated huge investments by telephone and cable television companies.

Public Policy

Public policy can have significant effects on the demand for capital. Such policies typically seek to affect the cost of capital to firms. For example, through an introduction of accelerated depreciation which did not change the actual rate at which assets depreciated, but it cut tax payments during the early years of the assets’ use and thus reduced the cost of holding capital. Or through changes in taxation in order to reduce the cost of capital for firms. Or through a reduction in taxes on corporate profits (called the corporate income tax) in order to stimulate investment.

Accelerated depreciation and lower taxes on corporate profits all increase the demand for private physical capital.

Key concepts

· The quantity of investment demanded in any period is negatively related to the interest rate. This relationship is illustrated by the investment demand curve.

· A change in the interest rate causes a movement along the investment demand curve. A change in any other determinant of investment causes a shift of the curve.

· The other determinants of investment include expectations, the level of economic activity, the stock of capital, the cost of capital goods, other factor costs, technological change, and public policy.