The variability of investment can be explained by multiple factors according to investment theories and empirical research. Key factors include interest rates, economic growth, technological progress, investor sentiment and government policies. These factors interact with each other and jointly determine the dynamics of investment in the economy. Understanding what drives investment fluctuation helps policymakers adopt appropriate measures to stabilize the economy.
Interest rate level significantly affects investment decisions
The level of interest rates is a key factor influencing investment. Higher interest rates increase the cost of capital, making investment projects less profitable. Thus firms and individuals tend to invest less when rates are high. Quantitative investment models like the neoclassical model formalize this mechanism and quantify the interest rate impact. Empirical studies also confirm the negative relationship between interest rates and business fixed investment across countries and over time.
Economic growth prospects are a main driver of investment
The growth outlook of the overall economy also drives investment substantially. When the economy is strong and growing, there are more profitable opportunities for companies to pursue, providing great incentives to invest in equipment, factories, technology etc. The accelerator model of investment describes how company investment responds to changes in economic activity and sales. Empirically, investment rates are found to be procyclical and lead the business cycle, confirming its dependence on growth expectations.
New technologies spur waves of investment in their adoption
The emergence of major new technologies like IT, biotech and renewable energy periodically spurs new waves of investment by companies aiming to adopt these innovations. The prospect of higher productivity or new revenue opportunities leads firms to invest heavily in embedding the new tech in their business models and operations, until the limits of the technology are reached. Government policies to promote technology development further enable this investment-driving effect of technological progress.
Investor optimism and pessimism cause asset price swings
Shifts in investor sentiment between optimism and pessimism can fuel major asset price swings, prompting changes in investment activity. High optimism leads to surging asset valuations and easier financing conditions, encouraging greater investment in financial and real assets. By contrast, waves of pessimism lead to plunging asset prices, tighter financing constraints and large drops in investment. These sentiment-driven investment cycles can amplify business cycles through their impact on spending.
In summary, interest rates, economic growth, technology and investor sentiment are key variables explaining the variability of investment over time. Their movements lead to fluctuations in investment through changes in expected profitability, availability of financing, risk perceptions and asset valuations.