While the investment line is commonly assumed to be horizontal, reflecting autonomous investment, it realistically has a positive slope, indicating induced investment. Induced investment means that investment expenditures are based on the aggregate level of income or production in the economy. Investment expenditures are induced because business firms are prone to use profits generated by a growing, expending economy to finance capital investment. If business is good, production is up, and revenue is increasing, then so too are profits. This makes it easy for business firms to finance capital investment.

However, a number of other factors also affect investment expenditures independent of income. For example, a typical business firm like The Wacky Willy Company, makers of Wacky Willy Stuffed Amigos, might decide to increase its investment expenditures by purchasing several brand new sewing machines. This extra spending was NOT the result of a sudden windfall of profit brought on by a growing, prosperous economy.

Rather, this expenditure was undertaken for "other reasons" unrelated to income or production. The specific reason underlying The Wacky Willy Company's increase in spending was to replace a factory full of old sewing machines that were destroyed when a passing thunderstorm sent an electrical power surge through the factory that fried the circuits of old machines.

In addition, the existing machines were extremely old, manufactured in the 1930s, and the interest rate was extremely low, reducing the cost of borrowing the funds used for the investment spending.

What They Do

Determinants

The exhibit to the right presents the investment line, labeled I. Investment expenditures determinants can trigger either an increase or a decrease in investment expenditures.

• Increase in Investment Expenditures: An increase in investment expenditures is illustrated by an upward shift of the investment line. At each income and production level, the business sector has greater investment expenditures. Click the [Increase] button to illustrate.


• Decrease in Investment Expenditures: A decrease in investment expenditures is illustrated by a downward shift of the investment line. At each income and production level, the business sector has fewer investment expenditures. Click the [Decrease] button to illustrate.

What They Are

• Interest Rates: Higher interest rates increase the cost of the borrowing used to finance most types of investment expenditures (such as factories, delivery vehicles, and sewing machines). If the cost of borrowing increases, the business sector is less likely to undertake the resulting expenditures on capital goods. As such, investment expenditures decrease and the investment line shifts down. Lower interest rates work in the opposite manner, causing an upward shift of the investment line.


• Expectations: If business firms are optimistic about future economic prospects and expect an improving economy, then they are more likely to increase investment expenditures in the present, even if current income is unchanged or falling. The result is an increase in investment expenditures and an upward shift of the investment line. Pessimistic expectations of a declining economy are then likely to cause a reduction in investment expenditures and a downward shift of the investment line.


• Capital Assets: The accumulation of capital assets--factories, buildings, tools, and machinery--is the goal of investment. An increase in the existing stock of business capital goods that results from past investment means that further investment expenditures and purchases are not needed. Why building another factory, when a brand new one was just completed? This causes a decrease in investment expenditures and a downward shift of the investment line. Of course, a reduction in the stock of capital assets, such as what might occur through depreciation, has the opposite effect, investment expenditures increase and the investment line shifts upward.


• Technology: Technology is the body of knowledge that the economy possesses about production techniques. An advance in technology is embodied in the goods produced or the capital used for production. This invariably triggers the need for a wide range of capital goods for production, distribution, and consumption. This causes an increase in investment expenditures and an upward shift of the investment line, even if current income is constant or declining. A drop off in technology, although less likely, then causes a decrease in investment expenditures and a downward shift of the investment line.


• Capital Prices: Like any good, the demand for capital is governed by the law of demand. A lower price of capital leads to an increase in the quantity demanded of capital. This is another way of saying that investment expenditures for capital increases and thus the investment line shifts up. An increase in the capital prices then causes a decrease in the quantity demanded, a decline in investment expenditures, and a downward shift of the investment line.