Capital Investment

Capital Investment

Department of Economics and BusinessBIS Phuket

Capital investment spending has an important effect on both the demand and supply side of the economy. This presentation considers the basic theories of investment, its impact on AD and AS.

Capital Investment

What is Investment?

Capital Investment Is spending on capital goods that will allow increased

output of goods and services in the future Investment is not saving in financial assets such as

shares and bonds

• Fixed Capital: plant and machinery, buildings, new technology

• Working Capital: spending on stocks of finished goods and raw materials / components

• Human Capital (not included in the investment data) – building up the stock of human (labour) qualities and skills

Capital Investment

Why Invest?

More Demand Improve efficiency through better technology Exploit economies of scale (lower LRAC) Investing in new technology to remain competitive

against other producers

Capital Investment

Factors affecting Investment

• The rate of interest- higher interest rates increases the cost of borrowing by firms and may make some investments unprofitable. It may also affect….

• Consumer demand- higher demand requires higher output, and therefore increased productive output. This may itself be affected by

• Spare capacity. If demand is increasing, but firms have spare capacity then they may not need to invest in additional machines etc

• Firms’ Profitability. If profits are high then they can afford to invest. It also has an impact on….

• Business confidence. If this is high then businesses may invest more

• Government Policies- such as subsidies and incentives to invest

• Banking and Financial institutions support to businesses.

Capital Investment

The Importance of Spare Capacity

88 89 90 91 92 93 94 95 96 97 98 99 00 0120

30

40

50

60

70

80

% of manufacturing firms operating with spare capacity

SPARE CAPACITY IN MANUFACTURING INDUSTRY

When demand is high and many businesses are operating close to full capacity, then planned capital spending may rise – businesses are looking to expand their production potential by adding to their existing capital stock

Low levels of capacity utilisation act as a constraint on investment

Capital Investment

Importance of Business Confidence

Investment projects inevitably involve a degree of risk Revenue streams are uncertain (particularly in industries

and markets that are sensitive to cyclical and exchange rate fluctuations)

Costs are subject to change over time There is no guarantee that a project will yield the

expected (or required) rate of returnChanges in business confidence can have a huge impact

on planned capital spending projectsConfidence is affected by many factors – but is driven

mainly by expectations (e.g. of future demand, costs, taxation etc)

A drop in business optimism can lead to delays in capital projects being given the go ahead or cancellations of entire projects

Capital Investment

Business Confidence Trends

88 89 90 91 92 93 94 95 96 97 98 99 00 01

CBI Industrial Trends Survey (Quarterly)

-80

-60

-40

-20

0

20

40

0

net balance of respondents

Business OptimismPlanned Investment

BUSINESS OPTIMISM AND PLANNED INVESTMENT

Business confidence is inherently volatile and unpredictable. Committing a business to expensive projects requires a cold and calculated assessment of the potential costs and returns

Capital Investment

What Constrains Investment Spending?

Constraints on Capital Investment (CBI Survey Evidence)

  Percentage of respondents citing as a factor

  Oct 2000 Jan 2001 April 2001 July 2001

Inadequate expected net rate of profit

51 51 45 40

Shortage of internal finance i.e. from retained profits

20 18 21 21

Problems in raising external finance 6 3 5 7

The cost of finance (i.e. interest rates on loan finance)

3 5 3 2

Uncertainty about future demand in their industry

44 48 56 51

Capital Investment

The Importance of Capital Investment to the Economy

The Government's central objective is to achieve high and stable levels of growth and employment. And, to achieve this requires a sustained expansion of our productive potential. An increase in the share of national income given to capital investment is seen as a key source of long-term economic growth, for new investment can embody technological progress and act as a stimulant to improvements in labour productivity

Capital Investment

Investment and Aggregate Demand

Investment is an important component of aggregate demand A change in investment can have a multiplier effect on

the overall level of national income E.g. a £100 million capital project should lead to a much

larger final increase in equilibrium GDPInitial boost to aggregate demand and outputEmployment creation effectsOutput generates further incomes and spending through the circular flow

If extra investment improves the international competitiveness of Thai businesses in domestic and international markets – this injects extra demand into the economy through higher exports

Capital Investment

AD1

100

6.0 Y1

LAS

SAS0

Y2

AD0

105

0

Pri

ce level

Investment Adds to Aggregate Demand

LRAS

Higher capital spending boosts aggregate demand

Some capital spending leaks from the circular flow through imports

GDP

Capital Investment

Investment and Aggregate Supply

Capital spending can boost the supply-side of the economy We can produce more New capital means better technology – improving

efficiency Often a time lag between new capital investment being

used and efficiency improvingTraining requiredInvestment requires sufficiently high level of demand for it to be fully utilised/used

Higher levels of investment increase the scope for non-inflationary economic growth over time

Capital Investment Real GDP

6.0 Y3 Y40

Pri

ce level

Improvements in Long Run Aggregate Supply

LRAS Higher rates of capital investment boost the productive capacity of the economy – a source of long-term economic growth

If there is a rise in long run aggregate supply the economy can now sustain a higher level of demand

If aggregate demand shifts out, the economy can meet the extra demand because of the outward shift in LRAS

AD2

AD1

LRAS2

Real GDP