Investment spending is a critical component of macroeconomic analysis and the business cycle. It refers specifically to expenditures made by firms and governments on capital goods, i.e. goods that will be used for future production rather than present consumption. This includes items like business equipment, machinery, buildings, factories, etc. Tracking investment spending trends provides insight into the expansion and contraction phases of the economy. There are four key characteristics of investment spending that help explain its role and importance in macroeconomics.
Investment Spending Fluctuates over the Business Cycle
Investment spending is more volatile over the business cycle compared to other components of GDP like consumption. During economic expansions, investment spending accelerates as businesses feel confident about future growth prospects. However, during recessions investment collapses as firms pull back. The volatility arises because investment requires firms to make guesses about the future based on current conditions. If the economic outlook sours, investment plans are quickly discarded.
Investment Spending Has a Multiplier Effect
According to Keynesian macroeconomics, investment spending has a larger multiplier effect on GDP compared to other forms of spending. This is because investment directly increases the economy’s productive capacity for the future. The new factories, equipment, etc. make workers more productive, enabling more output potentially for years to come. Thus a $1 increase in investment can boost GDP by more than $1 going forward.
Investment Drives Growth in Productive Capacity
A fundamental source of economic growth over time is expanding the economy’s productive capacity. This is accomplished through investment spending on new capital stock like plants, technology, equipment, etc. In the Solow growth model, increasing capital per worker is a driver of growth in potential output per capita. Tracking investment spending thus provides insight into the economy’s capacity for long-run growth.
Investment Spending Stems from Expectations
What drives business investment spending is largely based on expectations about future market conditions and growth prospects. When businesses are confident about the future, they ramp up capital expenditures. However, if uncertainty prevails, investment plans get scaled back or postponed. Animal spirits is a term referring to the central role played by difficult-to-quantify expectations and confidence in driving investment.
In summary, investment spending refers specifically to expenditures on capital goods used for future production. It is a volatile component of GDP that provides insight into the business cycle. Investment also plays a pivotal role in expanding productive capacity and long-run growth. Expectations are key factors driving investment spending trends.