Department of Economics and BusinessBIS Phuket Capital Investment Capital investment spending has an important effect on both the demand and supply side of the economy. This presentation considers the basic theories of investment, its impact on AD and AS. Department of Economics and BusinessBIS Phuket

Fixed Capital: plant and machinery, buildings, new technology What is Investment? Capital Investment Is spending on capital goods that will allow increased output of goods and services in the future Investment is not saving in financial assets such as shares and bonds Fixed Capital: plant and machinery, buildings, new technology Working Capital: spending on stocks of finished goods and raw materials / components Human Capital (not included in the investment data) – building up the stock of human (labour) qualities and skills

Why Invest? More Demand Improve efficiency through better technology Exploit economies of scale (lower LRAC) Investing in new technology to remain competitive against other producers

Factors affecting Investment The rate of interest- higher interest rates increases the cost of borrowing by firms and may make some investments unprofitable. It may also affect…. Consumer demand- higher demand requires higher output, and therefore increased productive output. This may itself be affected by Spare capacity. If demand is increasing, but firms have spare capacity then they may not need to invest in additional machines etc Firms’ Profitability. If profits are high then they can afford to invest. It also has an impact on…. Business confidence. If this is high then businesses may invest more Government Policies- such as subsidies and incentives to invest Banking and Financial institutions support to businesses.

The Importance of Spare Capacity Low levels of capacity utilisation act as a constraint on investment When demand is high and many businesses are operating close to full capacity, then planned capital spending may rise – businesses are looking to expand their production potential by adding to their existing capital stock

Importance of Business Confidence Investment projects inevitably involve a degree of risk Revenue streams are uncertain (particularly in industries and markets that are sensitive to cyclical and exchange rate fluctuations) Costs are subject to change over time There is no guarantee that a project will yield the expected (or required) rate of return Changes in business confidence can have a huge impact on planned capital spending projects Confidence is affected by many factors – but is driven mainly by expectations (e.g. of future demand, costs, taxation etc) A drop in business optimism can lead to delays in capital projects being given the go ahead or cancellations of entire projects

Business Confidence Trends Business confidence is inherently volatile and unpredictable. Committing a business to expensive projects requires a cold and calculated assessment of the potential costs and returns

What Constrains Investment Spending? Constraints on Capital Investment (CBI Survey Evidence)   Percentage of respondents citing as a factor Oct 2000 Jan 2001 April 2001 July 2001 Inadequate expected net rate of profit 51 45 40 Shortage of internal finance i.e. from retained profits 20 18 21 Problems in raising external finance 6 3 5 7 The cost of finance (i.e. interest rates on loan finance) 2 Uncertainty about future demand in their industry 44 48 56

The Importance of Capital Investment to the Economy The Government's central objective is to achieve high and stable levels of growth and employment. And, to achieve this requires a sustained expansion of our productive potential. An increase in the share of national income given to capital investment is seen as a key source of long-term economic growth, for new investment can embody technological progress and act as a stimulant to improvements in labour productivity

Investment and Aggregate Demand Investment is an important component of aggregate demand A change in investment can have a multiplier effect on the overall level of national income E.g. a £100 million capital project should lead to a much larger final increase in equilibrium GDP Initial boost to aggregate demand and output Employment creation effects Output generates further incomes and spending through the circular flow If extra investment improves the international competitiveness of Thai businesses in domestic and international markets – this injects extra demand into the economy through higher exports

Investment Adds to Aggregate Demand LRAS LAS Higher capital spending boosts aggregate demand Some capital spending leaks from the circular flow through imports Price level SAS0 105 100 AD0 AD1 6.0 Y1 Y2 GDP

Investment and Aggregate Supply Capital spending can boost the supply-side of the economy We can produce more New capital means better technology – improving efficiency Often a time lag between new capital investment being used and efficiency improving Training required Investment requires sufficiently high level of demand for it to be fully utilised/used Higher levels of investment increase the scope for non-inflationary economic growth over time

Improvements in Long Run Aggregate Supply Higher rates of capital investment boost the productive capacity of the economy – a source of long-term economic growth If there is a rise in long run aggregate supply the economy can now sustain a higher level of demand If aggregate demand shifts out, the economy can meet the extra demand because of the outward shift in LRAS LRAS LRAS2 Price level AD2 AD1 6.0 Y3 Y4 Real GDP Real GDP