Identify the key factors that determine the level of investment in a
modern economy and comment on the view that the accelerator model of
investment is too limited to offer a full explanation.
The term ‘investment’ in economics refers to the use of capital to
create productive facilities such as plant and equipment, buildings
and so on. It can also refer to expenditure on ‘human capital’, that
is, investment on education and training as an investment in the
quality of the labour force. Total investment includes spending by
firms and Government on all types of capital goods and makes up about
one-fifth of total spending in an economy.
Investment inevitably requires a sacrifice. Usually the sacrifice is
reduced consumer expenditure in order to free capital resources for
investment today so that output can be higher tomorrow. Investment is
the most volatile element of national expenditure and changes in this
important variable generate, in turn, multiplier effects on the rest
of the economy. It is, perhaps, the single most crucial element in
determining the success of the economy and cyclical instability and
economic growth are thought to be closely related correlated with the
trends in investment expenditure.
First, a firm that plans to invest must assess the cost of capital
(mainly the interest rate) and compare it with the expected return on
the investment. If expected yield exceeds cost, the investment
project may proceed. Since machines and factories generate that yield
over time, it is necessary to calculate the present value of future
flows of revenue in order to produce a fair comparison. In effect, in
assessing the rate of return on additional investment projects, the
firm is determining the marginal efficiency of capital.
Investment will also depend on several other factors. Business
expectations could be crucial; investment opportunities (such as a
major new innovation) will have an important effect; the availability
of investment funds could be significant; and rising income levels
and/or profits will also have an impact on aggregate investment.
Finally, changes in Government policy with respect to investment in
the infrastructure, housing or state industries will affect overall
investment levels in the economy.
The accelerator theory has been used to elaborate on the link between
investment and rising income as noted above. The theory suggests that
the current net level of investment will depend on past changes in
income in the economy. Put simply, It = v (Yt – Yt-1) : where It is
net investment in the current time period and Yt – Yt-1 is the change
in income over the last time period. The term ‘v’ is the accelerator
coefficient which is a constant.
More complex and sophisticated accelerator models can be developed
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me on a volunteer project I did in high school. The summer after my junior year
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