Unit 3 Aggregate demand and the multiplier model
3.11 Why is investment volatile?
Households tend to smooth their consumption spending when they can, but there is no similar motivation for a firm to smooth investment spending. Firms increase their stock of machinery and equipment and build new premises whenever they identify an opportunity to make profits. But, unlike eating and most other consumption expenditures, investment can be postponed. There are several reasons why this is likely to produce clusters of investment projects at some times and few at other times.
New technology
When an innovation like the spinning jenny in the Industrial Revolution or spreadsheet programmes in the information and communications technology (ICT) revolution is introduced, firms using the new technology can produce output at lower cost or produce higher-quality output. They expand their share of the market. Firms that fail to follow may be forced out of business because they are unable to make a profit using the old technology. But new technology means that firms must install new machines. As firms do this, there is an investment boom. This will be amplified if the firms producing the machinery and equipment need to expand their own production facilities to meet the extra demand expected.
In this case, investment by one firm pushes other firms to invest: if they don’t, they may lose market share or even be unable to cover their costs and eventually have to leave the industry. But investment by one firm can also pull other firms to invest by helping to increase their market and potential profits.
The high-tech investment boom in the US can be identified in the aggregate data. From the mid-1990s, new ICT was introduced into the US economy on a large scale. Figure 3.20 shows the sustained growth of investment in new technologies—around 10% or higher—through the second half of the 1990s. Nothing similar is visible in the data since then.
Figure 3.20 Investment in new technologies and the dot-com bubble (1991–2022).
US Bureau of Economic Analysis. 2023. Fixed Assets Accounts Tables. FRED. 2023. NASDAQ Composite Index. Note: the series are in current US dollars. NASDAQ value is the yearly average of the close price value of the NASDAQ. Investment in new technologies is the investment in information processing equipment, computers and peripheral equipment, communication equipment, communication structure, and investments for software, semiconductors, and other electronic components and computers.
Figure 3.20 also shows the behaviour of the NASDAQ index. The NASDAQ is the US stock exchange where shares (or stocks) in high-tech companies are bought and sold. The index is an average of the prices at which these shares are traded.
The index rose strongly from the mid-1990s to an all-time peak in 1999 as stock market investors’ confidence in the profitability of new tech firms grew. Investment in IT equipment (the red line) grew rapidly as a result of this confidence, but dropped sharply following the collapse in confidence that caused the fall of the stock market index. This suggests that overinvestment in machinery and equipment had occurred: investment did not begin growing again until 2003. Robert Shiller, the economist, argued that the NASDAQ index was driven high by what he called ‘irrational exuberance’. Beliefs in the future of high-tech led not only to share prices rising to levels that were unsustainable, but also to excessive investment in machinery and equipment in the high-tech sector.
Robert Shiller explains in a VoxEU podcast how ‘animal spirits’ contribute to the volatility of investment and to both overinvestment and a stock market bubble.
Units 5 and 6 will show why, on the basis of ‘present value’ we might expect investment and stock prices to rise and fall together.
Credit constraints
In Section 3.10, we highlighted the role of credit constraints for consumption behaviour. Credit constraints also affect firms, and are another reason for the clustering of investment projects and the volatility of aggregate investment. In a buoyant economy, profits are high and firms can use these profits to finance investment projects. They will also typically find it easier to borrow and to issue new shares. Access to finance from sources outside the firm is also easier: in the US high-tech boom, for example, the expansion of the NASDAQ exchange reflected the appetite of investors to provide finance by buying shares in firms in the emerging ICT industries. In Unit 6, we examine this mechanism in more detail.
A coordination problem: Vicious and virtuous circles
- capacity utilization
- A firm, industry, or entire economy is at full capacity utilization if it is producing as much as the stock of its capital goods and current knowledge will allow. If is is producing less, it is ‘below full capacity utilization’ or ‘at a low capacity utilization rate’.
To understand how one firm’s investment can induce another firm to invest, think of a local economy consisting of just two firms. Firm A’s machinery and equipment are not fully used, so although the firm can produce more if it hires more employees, there is not enough demand to sell the products it would produce. This is a situation of low capacity utilization. For the owners of Firm A to undertake new investment, they need to anticipate growing demand for their output.
Firm B has the same problem. Because of low capacity utilization, profits are low for both. Incomes in the local economy remain low, and so does demand. Therefore, when we think about both firms together, we have a vicious circle (Figure 3.21).
Figure 3.21 Low expected demand for the firm’s products creates a vicious circle.
If the owners of both A and B decide to invest in new capacity and hire at the same time, they would employ more workers, who would spend more, increasing the demand for the products of both firms. The profits of both would rise, and we have a virtuous circle (Figure 3.22):
Figure 3.22 High expected demand for the firm’s products creates a virtuous circle.
These two circles highlight the role of expectations of future demand. The incentive to invest depends on expected demand, which in turn depends on the behaviour of other actors in the economy. The firms in the vicious circle have a coordination problem. If both invested together, everyone would be better off.
Question 3.14 Choose the correct answer(s)
Figures 3.21 and 3.22 show that total investment spending can be volatile because the interaction of individual firms’ decisions can lead to vicious (low-profit) or virtuous (high-profit) circles. Which of the following might encourage all firms in the economy to behave in such a way that they all increase their investment spending together?
- A major technological breakthrough is likely to encourage more investment in the automobile industry and in battery manufacture. Some firms may also recognize it as having implications for their industry, even though they do not produce electric cars. However, this single breakthrough is unlikely to encourage firms in all sectors to increase investment.
- The disruption to production in the war-affected region and to international trade caused by such a war is likely to have created uncertainty for firms about expected future demand and the prices of inputs to production. The end of the war would reduce uncertainty and boost confidence among firms in the economy, leading to higher investment.
- Encouragement from the government is unlikely to have much effect. Investments are risky and firms are unlikely to invest just because governments ask them to do so. However, such encouragement might have some effect if combined with government action, such as spending on infrastructure.
- An increase in government spending will encourage all firms to expect a higher demand for their products, which would have a beneficial effect on investment plans across the economy.