Theoretical models of Investment determinants

What are the factors that determine Investments?

John Keynes, in his Theory, suggested the existence of a function independent of investment in the economy and emphasized that the determinants of savings were different in nature from those corresponding to the investment, which represented a challenge to the prevailing view in those times when the real interest rate was the main variable that allowed the balance between saving and investment.

According to Keynes, the investment was determined by the difference between the real cost of capital relevant to businesses and the marginal efficiency of capital (capital productivity). He also noted the importance of the expectations in determining the investment and estimates of the expected profitability of investment decisions, as well as volatile nature inherent in investment due to the uncertainty in the projection of their yields.

Theoretical models of Investment determinants

Existing theoretical models can be classified into the following four major categories:

  1. Accelerator model,
  2. The neoclassical model,
  3. The model of Tobin’s Q and
  4. Disequilibrium model.

1. Accelerator model of Investments

After the contributions of Keynes, in the late fifties, the models to explain the behavior of investment is linked to Harrod-Domar growth model and led to the accelerator theory. Under this view, investment is a linear proportion of the variation in the output of the economy, ie, capital investment increases when economic growth accelerates. Given a reason incremental capital / output, investment requirements are determined by associating them with a particular goal of production growth. Therefore, one can determine the investment requirements of the economy from a specific rate of growth of the product.

The model emphasizes the role of demand in determining investment, but does not take into account the role of expectations, profitability or cost of capital.

2. Neoclassical Model of Investments

Restricted approach to accelerator model led to the formulation of neoclassical model. This approach is the demand function for capital that stems from the concept of factor substitution and the optimizing behavior of employers (profit maximization or cost minimization). According to the reduced form of this model, the desired capital stock is a function of the level of output and the cost of capital (Hall and Jorgenson,1967); this variable in turn, depends on the price of capital goods, the real interest rate and the depreciation. The lags between investment decisions and the realization of it creates a gap between current investment stocks and the desired level.

It is important to highlight the fact that this model does not consider the expectations about the future behavior of other significant macroeconomic variables such as the price level and interest rates although desired capital stock is determined based on expected values of production and sales. Also, this model has been subject to some criticism because of the consistency and credibility of its assumptions:

  • Perfect competition and exogenously given product are inconsistent;
  • The assumption of static expectations is inappropriate because investment decisions follow a forward looking process;
  • The lag between investment decisions and the realization are introduced in an ad hoc manner.

3. Tobin’s Q model of Investments

This theory was developed in the late sixties by James Tobin, who suggests that investment is a function of the ratio of the market value of existing capital goods and the replacement cost of new capital goods. Tobin calls this ratio the ratio Q. The higher this ratio, the greater the incentive for investors to increase their capital stock. Also, this author offers two reasons why this ratio differs from the unit: delays in delivery and adjustment costs or installation of capital goods.

Abel (1982) and Hayashi (1982) reconcile the neoclassical and Tobin’s Q approaches, showing that the latter is derived from the optimal capital problem faced by a company under the assumption of convex adjustment costs. Under this scheme, the investment decisions depend on the marginal value of Q, that is, the ratio between the increase in the value of the firms due to an additional unit of installed capital relative to its replacement cost. However, the marginal Q is unobservable and usually differ from the average value of Q (the ratio of the market value of existing capital and replacement cost), except on the assumption of perfect competition and constant returns to scale. They also differ when there are restrictions on the goods and financial markets in which case the average Q will not provide information relevant to investment decisions.

Meanwhile, Serven and Solimano op.cit. question one of the basic assumptions of Q theory, namely that firms can freely change its capital stock (having the ability to increase or decrease its capital stock until Q equals one). They note that the cost of divesting can often be greater than that of investing, the irreversibility of investment.

4. The Disequilibrium model of Investments

In Disequilibrium model, the investment is determined by the profitability and the demand for the product. Investment decisions go through two stages, the decision to expand the level of productive capacity and the decision on the capital intensity of the additional capacity. The first of these decisions depends on the level of capacity utilization in the economy as an indicator of demand conditions and second, profitability as the relative cost of capital and labor.

Disequilibrium models are often criticized for the simplicity of the assumptions about expectations. However, as indicated by Serven and Solimano op.cit., Market expectations of balance and rational expectations are not necessarily inconsistent.