Investment Function
The investment function describes the determinants of business investment, the spending by firms on capital goods, and relates investment to factors such as the cost of capital, expected profitability, and the state of demand. Investment is one of the most volatile components of aggregate expenditure and a key channel through which monetary and fiscal policies affect the economy.
The Neoclassical and Accelerator Approaches
The neoclassical approach derives investment from the optimal capital stock, which equates the marginal product of capital with its user cost. User cost depends on the purchase price of capital, the interest rate, depreciation, and tax treatment. Investment is the adjustment of the actual capital stock toward the desired level.
The accelerator model relates investment to changes in output. Because the desired capital stock is proportional to output, investment is proportional to the change in output. The accelerator captures the procyclicality of investment but is a reduced-form relationship rather than a theory of the firm's behaviour.
Tobin's Q and the Cost of Adjustment
Tobin's q relates investment to the ratio of the market value of capital to its replacement cost. When q exceeds one, firms have an incentive to invest, because the market values additional capital more highly than its cost. The q theory provides a link between asset prices and investment, and it clarifies how expectations of future profitability affect current investment.
Adjustment costs explain why investment responds gradually rather than immediately to changes in desired capital. Because installing capital is costly, firms spread investment over time, and current investment depends on expectations of future conditions. This forward-looking character makes investment sensitive to uncertainty and to the credibility of policy.
Financial Factors and Uncertainty
The cost of external finance matters because investment is largely financed externally. The availability of internal funds, the state of the banking system, and the strength of balance sheets affect the cost and availability of credit. Financial frictions can raise the external finance premium above the cost of internal funds, affecting investment independently of the interest rate.
Uncertainty also affects investment. Where firms can wait for the resolution of uncertainty, the option value of delaying an irreversible investment can exceed the value of proceeding, so that firms delay investment even when projects appear profitable on expected value grounds.
Empirical Evidence
Empirical work finds that investment responds to output, user cost, and cash flow, and that financial factors and uncertainty matter. The responsiveness of investment to tax policy, to monetary policy, and to expectations has been extensively studied, with estimates varying across countries and periods.
Empirical Investment Equations
Empirical work estimates investment equations relating investment to output, the cost of capital, cash flow, and measures of uncertainty. The estimated sensitivity of investment to each factor varies across countries, sectors, and periods, and the results depend on the specification and the data available.
Cash flow is often found to matter for investment, particularly for firms facing financing constraints, a finding that supports the importance of financial factors. The sensitivity of investment to tax policy, including depreciation allowances and investment tax credits, is central to the evaluation of business tax reform.
Monetary Policy and Investment
Investment is a key channel through which monetary policy affects the economy. Lower interest rates reduce the cost of capital, raising the desired capital stock and stimulating investment. Monetary policy also affects investment through credit availability and through the effect on expectations of future demand.
The strength of these channels depends on the structure of finance, the state of balance sheets, and the response of expectations. When firms are highly leveraged or when financial conditions are stressed, the interest rate channel may be weakened, prompting the use of credit policy and other measures.
Uncertainty and Irreversibility
The theory of investment under uncertainty emphasises the option value of waiting when investment is irreversible and information arrives over time. The prospect of new information makes it optimal to delay investment even when a project is profitable in expected value terms, because waiting preserves the option to abandon and avoids commitment to a poor outcome.
This insight explains why investment can fall sharply during periods of elevated uncertainty, even when interest rates are low, and why credible and predictable policy can support investment. It also implies that the timing of policy announcements and the stability of the policy environment matter for investment decisions.
Cross-Country Differences
Investment rates vary widely across countries, reflecting differences in growth prospects, the cost of capital, the quality of institutions, and the business environment. Countries with secure property rights, efficient finance, and stable macroeconomies tend to invest more, and investment is a key determinant of long-run growth.
Policies to raise investment include macroeconomic stability, investment in infrastructure and education, improvements to the business environment, and measures to deepen financial markets. The effectiveness of these policies depends on the constraints that bind in each context.