Investment and Economic Activity

Read this chapter to examine factors that determine private investment and its link to output within the macroeconomy. Private investment plays an important role in the short run by influencing aggregate demand, and in the long run by influencing the rate of growth of the economy.

Start Up: Jittery Firms Slash Investment

In the recession that began in late 2007 in the United States, the first main element of GDP that faltered was the part of investment called residential structures. When housing prices started falling in 2006, new home construction slowed down. In 2008, this sector had shrunk by more than 40% from where it had been just a few years earlier.

In 2008, the part of investment that reflects business spending on equipment ranging from computers to machines to trucks also turned down. The only major part of investment left standing was business spending on structures – factories, hospitals, office buildings, and such. In late 2008, firms around the world seemed to be trying to outdo each other in announcing cutbacks.

Among automakers, it was not just the Detroit 3 cutting back. Toyota announced an indefinite delay in building a Prius hybrid sedan plant in Mississippi. Walgreen's, which had been increasing drugstore locations by about 8% a year, said it would expand by only about 4% in 2009 and by less than 3% in 2010. Package carrier FedEx announced a 20% decline in capital spending, on top of suspending pension contributions and cutting salaries. Even hospitals began scaling back on construction.

Companies around the world were announcing similar cutbacks. Consumer electronics maker Sony announced is was not only closing plants but also not moving forward in constructing an LCD television plant in Slovakia. With the drop in oil prices, oil companies were also cancelling planned projects right and left.

Choices about how much to invest must always be made in the face of uncertainty; firms cannot know what the marketplace has in store. Investment is a gamble; firms that make the gamble hope for a profitable payoff. And, if they are concerned that the payoff may not materialize, they will be quick to take the kinds of actions cited above – to slash investment spending.

Private investment plays an important role, not only in the short run, by influencing aggregate demand, but also in the long run, for it influences the rate at which the economy grows. That is, it influences long-run aggregate supply.

In this chapter, we will examine factors that determine investment by firms, and we will study its relationship to output in the short run and in the long run. One determinant of investment is public policy; we will examine the ways in which public policy affects investment.

Private firms are not the only source of investment; government agencies engage in investment as well. We examined the impact of the public sector on macroeconomic performance in the chapter devoted to fiscal policy. When we refer to "investment" in this chapter, we will be referring to investment carried out in the private sector.

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