Induced Investment

Induced investment is investment that is undertaken in response to changes in the level of output or of demand, as distinct from autonomous investment, which is undertaken independently of current conditions. The distinction is central to the analysis of the accelerator and of investment behaviour.

Concept

Induced investment is investment that firms undertake to expand capacity in response to an increase in demand for their products. When demand rises, firms that are operating near capacity will invest to expand, so that investment is induced by the change in output.

Autonomous investment is investment that is undertaken regardless of current output, for example investment driven by innovation or by expectations of long-term growth. The distinction is analytical, since in practice investment is influenced by both current conditions and longer-term factors.

The Accelerator

The accelerator model formalises the relationship between induced investment and output. The model holds that the desired capital stock is proportional to output, so that investment equals the change in the desired capital stock, which is proportional to the change in output.

The model implies that investment depends on the rate of change of output rather than its level. This explains why investment is more volatile than output, since a slowdown in growth, even if output continues to rise, reduces investment.

The simple accelerator has been refined to account for the cost of capital, for lags in the adjustment of the capital stock, and for the role of expectations. The refinements improve the empirical performance of the model, though the accelerator remains a central element of the analysis of investment.

Investment and the Business Cycle

The accelerator mechanism contributes to the volatility of investment over the business cycle. During an expansion, rising output induces investment, which raises demand further, amplifying the expansion. During a contraction, falling output reduces investment, which reduces demand further, amplifying the contraction.

The mechanism is an example of the interaction between the multiplier and the accelerator. The multiplier determines the effect of investment on output, and the accelerator determines the effect of output on investment. Together they can generate cycles, as the interaction amplifies and propagates shocks.

The interaction is central to the analysis of business cycles and to the design of stabilisation policy. It explains why investment is a major source of fluctuations and why policies that stabilise demand can also stabilise investment.

Determinants

The level of induced investment depends on the cost of capital, on the availability of finance, and on the expectations of firms. A rise in interest rates raises the cost of capital and reduces investment. A tightening of credit conditions reduces the availability of finance.

Expectations are central. Firms invest when they expect demand to grow, and they may delay investment when uncertainty is high. The effect of uncertainty on investment is a subject of research, and it is relevant to the analysis of the effects of policy.

The determinants of investment also include the tax treatment of investment, which affects the after-tax cost of capital, and the state of the capital stock, since firms with excess capacity have less need to invest.

Investment and Uncertainty

The decision to invest is made under uncertainty about future demand, costs, and technology. The theory of investment under uncertainty, developed by Avinash Dixit and Robert Pindyck, emphasises the option value of waiting, since a firm that invests irreversibly gives up the option to delay.

The option value of waiting implies that firms require a higher expected return before investing, and that investment responds less to changes in the cost of capital than the simple models predict. The effect is larger when uncertainty is high and when the investment is irreversible.

The implications for policy are significant. A policy that reduces uncertainty, for example by providing a stable framework, can raise investment without changing the cost of capital. A policy that is uncertain or reversible may have less effect than expected.

The Role of the Cost of Capital

The cost of capital is a central determinant of investment. It reflects the interest rate, the tax treatment of investment, and the required return on equity. A lower cost of capital raises the present value of the returns to investment and increases the incentive to invest.

The empirical evidence on the responsiveness of investment to the cost of capital is mixed. The estimates vary, and they are sensitive to the specification of the model and to the treatment of expectations.

The cost of capital is also affected by the availability of finance. Firms that are credit constrained may be unable to invest even when the expected return is high, since they cannot raise the funds. The effect of financial frictions on investment is a subject of research.

Investment and Corporate Governance

The governance of the firm affects the investment decision. Managers may invest in projects that serve their own interests rather than those of the shareholders, for example by expanding the firm beyond its optimal size.

The mechanisms of corporate governance, including the board of directors, the market for corporate control, and the structure of compensation, affect the alignment of the interests of managers and of shareholders. The design of these mechanisms affects the efficiency of investment.

The governance also affects the ability of the firm to commit to long-term investment. Firms that are subject to short-term pressure may underinvest in projects with long payback periods, even when the returns are high.

Summary

Induced investment responds to changes in output and to the cost of capital, and its analysis involves the accelerator, the role of uncertainty, and the governance of the firm. The determinants of investment are central to the analysis of the business cycle and of growth.

See also

• Macroeconomics
• Gross Capital Formation
• Keynesian Economics