The Volatility of Investment

Investment, measured as GPDI, is among the most volatile components of GDP. In percentage terms, year-to-year changes in GPDI are far greater than the year-to-year changes in consumption or government purchases. Net exports are also quite volatile, but they represent a much smaller share of GDP.

Given that the AD curve shifts by an amount equal to the multiplier times an initial change in investment, the volatility of investment can cause real GDP to fluctuate in the short run. Downturns in investment may trigger recessions.

Investment, Consumption, and Saving

Earlier we used the production possibilities curve to illustrate how choices are made about investment, consumption, and saving.

Figure The Choice between Consumption and Investment shows a production possibilities curve PPC for an economy that can produce two kinds of goods: consumption goods and investment goods. An economy operating at point A on PPC ₁ is using its factors of production fully and efficiently. It is producing C _A units of consumption goods and I _A units of investment each period. Suppose that depreciation equals Ia, so that the quantity of investment each period is just sufficient to replace depreciated capital; net investment equals zero. If there is no change in the labor force, in natural resources, or in technology, the production possibilities curve will remain fixed at PPC ₁.

Figure The Choice between Consumption and Investment

 

Now suppose decision makers in this economy decide to sacrifice the production of some consumption goods in favor of greater investment. The economy moves to point B on PPC ₁. Production of consumption goods falls to C _B, and investment rises to I _B. Assuming depreciation remains I _A, net investment is now positive. As the nation’s capital stock increases, the production possibilities curve shifts outward to PPC ₂. Once that shift occurs, it will be possible to select a point such as D on the new production possibilities curve. At this point, consumption equals C _D, and investment equals I _D. By sacrificing consumption early on, the society is able to increase both its consumption and investment in the future. That early reduction in consumption requires an increase in saving.

We see that a movement along the production possibilities curve in the direction of the production of more investment goods and fewer consumption goods allows the production of more of both types of goods in the future.

Key concepts

· Investment adds to the nation’s capital stock.

· Gross private domestic investment includes the construction of nonresidential structures, the production of equipment and software, private residential construction, and changes in inventories.

· Investment is the most volatile component of GDP.

· Investment represents a choice to postpone consumption – it requires saving.

 

 

Unit 9.2 Determinants of Investment

Learning objectives

1. Draw a hypothetical investment demand curve, and explain what it shows about the relationship between investment and the interest rate.

2. Discuss the factors that can cause an investment demand curve to shift.

· Interest rates play a key role in the determination of the desired stock of capital and thus of investment. Because investment is a process through which capital is increased in one period for use in future periods, expectations play an important role in investment as well.

· Capital is one factor of production, along with labor and natural resources. A decision to invest is a decision to use more capital in producing goods and services. Factors that affect firms’ choices in the mix of capital, labor, and natural resources will affect investment as well.

· Public policy affects investment. Some investment is done by government agencies as they add to the public stock of capital. In addition, the tax and regulatory policies chosen by the public sector can affect the investment choices of private firms and individuals.