Determinants of Investment

Abstract

This note discusses business fixed investment and the positive relationship between investment levels and the growth rate of Real GDP, known as the accelerator relationship.

Excerpt

UVA-G-0629

October 20, 2009

Determinants of Investment

Business fixed investment (BFI) is the largest subcomponent of gross private domestic investment (commonly referred to as I in the typical aggregate demand model). In some ways it is the most important component of GDP as it is the only one that also affects aggregate supply. The capacity of an economy to supply depends critically on the capacity of industry, which depends critically on BFI.

I is one of the most volatile components of GDP, as shown in Exhibit 1. Both of the recent recessions in the United States have been attributed to subcomponents of I. The tech bust of 2000 certainly was important in contributing to the recession of 2001–2002. High technology investments are certainly contained in the BFI portion of I. The recession that began in late 2007 was largely thought to have been incited by a decline in the residential fixed investment (housing) portion of I.

For this exposition, let us consider only BFI in our discussion of investment. Other assignments will discuss residential fixed investment and inventory investment, the other subcomponents of I.

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Keywords: capital consumption allowance, capacity, capital widening, capital deepening, GDP, accelerator relationship