Volatility of Investment Spending

1481 Words6 Pages
“Investment is the sacrifice of an immediate and certain satisfaction in exchange for a future expectation whose security lies in the capital invested” (Masse 1962). Investment take place when company after certain analysis concludes that buying new equipment, factories, machinery or other capital, will generate profit in the future, and of course this decision is based on firm’s expectations, as we can never be confident about the future. As it can be seen in the graph below gross capital formation or just investment is the most volatile component of GDP, and even more volatile than GDP. This essay will identify and explain main factors and theories which describe the cyclical nature of investment function, and how the firm’s expectations are formed. Chart 1 UK GDP, Consumption and Investment growth rate Accelerator principle of investment is crucial theory, which explains why the investment function always follows the GDP, and why it is more volatile than GDP. I*= v(Yt – Yt-1), where v is capital/output ratio, I* is optimal capital investment and Yt-Yt-1 is change in output in current period. If output increases, capital stock must increase in fixed relationship to maintain the condition I*=v(Yt) (Junankar, 1972) By this theory, when firms deciding how much to invest, they assume that in the next period increase or decrease in output would be same as the change in the current period. So, the expectations of the firms by this theory are based only on the past. This is why there is a strong relationship between GDP and investment function. During the boom in economy, firms are facing increase in sales, and expect sales to rise in the next periods, and therefore are investing new capital. Installation of new capital would happen until the economy will reach the peak, and beginning of the recession. Accelerator principle assumes that capital/output ratio is
Open Document