Source of information: http://www.econlib.org
Investment is one of the most important variables in economics. On its back, humans have ridden from caves to skyscrapers. Its surges and collapses are still a primary cause of recessions. Indeed, as can be seen in Figure 1, investment has dropped sharply during almost every postwar U.S. recession. As the graph suggests, one cannot begin to project where the economy is going in the near term or the long term without having a firm grasp of the future path of investment. Because it is so important, economists have studied investment intensely and understand it relatively well.
By investment, economists mean the production of goods that will be used to produce other goods. This definition differs from the popular usage, wherein decisions to purchase stocks (see stock market) or bonds are thought of as investment.
Investment is usually the result of forgoing consumption. In a purely agrarian society, early humans had to choose how much grain to eat after the harvest and how much to save for future planting. The latter was investment. In a more modern society, we allocate our productive capacity to producing pure consumer goods such as hamburgers and hot dogs, and investment goods such as semiconductor foundries. If we create one dollar worth of hamburgers today, then our gross national product is higher by one dollar. If we create one dollar worth of semiconductor foundry today, gross national product is higher by one dollar, but it will also be higher next year because the foundry will still produce computer chips long after the hamburger has disappeared. This is how investment leads to economic growth. Without it, human progress would halt. Investment need not always take the form of a privately owned physical product. The most common example of nonphysical investment is investment in human capital. When a student chooses study over leisure, that student has invested in his own future just as surely as the factory owner who has purchased machines. Investment theory just as easily applies to this decision. Pharmaceutical products that establish heightened well-being can also be thought of as investments that reap higher future productivity. Moreover, government also invests. A bridge or a road is just as much an investment in tomorrow’s activity as a machine is. The literature discussed below focuses on the study of physical capital purchases, but the analysis is more widely applicable.
In an economy that is closed to the outside world, investment can come only from the forgone consumption—the saving—of private individuals, private firms, or government. In an open economy, however, investment can surge at the same time that a nation’s saving is low because a country can borrow the resources necessary to invest from neighboring countries. This method of financing investment has been very important in the United States. The industrial base of the United States in the nineteenth century—railroads, factories, and so on—was built on foreign finance, especially from Britain. More recently, the United States has repeatedly posted significant investment growth and very low savings. However, when investment is funded from outside, some of the future returns to capital are passed outside as well. Over time, then, a country that relies exclusively on foreign financing of investment may find that it has very little capital income with which to finance future consumption. Accordingly, the source of investment finance is an important concern. If it is financed by domestic saving, then future returns stay at home. If it is financed by foreign saving, then future returns go abroad, and the country is less wealthy than otherwise.
Many authors, including Nobel laureate trygve haavelmo, contributed to the advance of the investment literature after the war. Dale Jorgenson published a highly influential synthesis of this and earlier work in 1963. His neoclassical theory of investment has withstood the test of time because it allows policy analysts to predict how changes in government policy affect investment. In addition, the theory is intuitively appealing and is an essential tool for any economist.
Here is a brief sketch. Suppose you run a firm and are deciding whether to purchase a machine. What should affect your decision? The first observation is that you should purchase the machine if doing so will increase your profits. For that to happen, the revenue you earn from the machine should at least be equal to the costs. On the revenue side, the calculation is easy. If, for example, the machine will produce one thousand donuts and you can sell them at ten cents apiece, then you know, after subtracting the noncapital costs such as flour, exactly how much extra revenue the machine will produce. But what costs are associated with the machine?
Suppose the machine lasts forever, so you do not have to worry about wear and tear. If you buy the machine, then it produces donuts and the machine’s manufacturer has your money. If you decide not to buy the machine, then you can put the money in the bank and earn interest. If the machine truly does not wear (i.e., depreciate) while you use it, you could, in principle, purchase the machine this year and sell it next year at the same price, and get your money back. In that case, you gain the extra revenue from selling donuts but lose the interest you could have had if you had just placed the money in the bank. You should buy the machine if the interest is less than the extra money you will make from the machine.
Jorgenson expanded this basic insight to account for the facts that the machine might wear out, the price of the machine might change, and the government imposes taxes. His “user cost” equation is a sophisticated model of investment, and economists have found that it describes investment behavior well. Specifically, a number of predictions of Jorgenson’s model have been confirmed empirically. Firms buy fewer machines when their profits are taxed more and when the interest rate is high. Firms buy more machines when tax policy gives them generous tax breaks for doing so.
Investment fluctuates a lot because the fundamentals that drive investment—output prices, interest rates, and taxes—also fluctuate. But economists do not fully understand fluctuations in investment. Indeed, the sharp swings in investment that occur might require an extension to the Jorgenson theory.
Despite this, Jorgenson’s theory has been a key determinant of economic policy. During the recession of 2001, for example, the U.S. government introduced a measure that significantly increased the tax benefits to firms that purchased new machines. This tax “subsidy” to the purchases of machines was meant to stimulate investment at precisely the time that it would otherwise have plummeted. This countercyclical investment policy follows significant precedent. In 1954, accelerated depreciation was introduced, allowing investors to deduct a larger fraction of the purchase price of a machine than had previously been allowed. In 1962, President John F. Kennedy introduced an investment tax credit to stimulate investment. This credit was enacted and repealed numerous times between then and 1986, when it was finally repealed for good. In each case, the Jorgenson model provided a guide to policymakers of the likely impact of the tax change. Empirical studies have confirmed that the predicted effects occurred.