Investment plays a crucial role in determining aggregate demand, influencing both current economic performance and long-term productive capacity. This section explores its definition, types, and key determinants in the context of the UK economy.
Definition of investment
In macroeconomic terms, investment refers to the expenditure by firms on capital goods—these are goods not used up in the production process, but instead used to produce other goods and services over time. Capital goods include machinery, tools, buildings, infrastructure, and technology.
Investment, in this context, does not include financial investments such as the purchase of shares or bonds. These are considered part of financial markets and not part of the production process.
Investment is one of the four components of Aggregate Demand (AD). The formula for aggregate demand is:
AD = C + I + G + (X – M)
Where:
C stands for consumption by households
I is investment by firms
G is government spending
(X – M) is net exports (exports minus imports)
Investment contributes not only to current demand for capital goods but also determines the future productive potential of the economy.
Gross investment vs net investment
It is important to distinguish between gross investment and net investment.
Gross investment is the total amount of capital spending by firms within a specific period. This includes all new purchases of capital goods.
Net investment is calculated as:
Net Investment = Gross Investment – Depreciation
Depreciation refers to the wear and tear or obsolescence of existing capital. Over time, machines break down, and buildings require maintenance or replacement. This loss of value must be accounted for to determine how much of the capital stock is truly increasing.
If gross investment is greater than depreciation, net investment is positive, meaning the economy's productive capacity is expanding. If depreciation equals gross investment, net investment is zero, and the capital stock remains constant. If depreciation exceeds gross investment, net investment is negative, indicating a shrinking capital base.
For example, if a company spends £200 million on new equipment, and £50 million worth of existing equipment depreciates, the net investment is £150 million.
Influences on investment decisions
Investment decisions are shaped by a range of factors that affect firms' expectations, costs, and access to finance. Some influences are based on measurable economic variables, while others stem from psychology and sentiment. Understanding these factors helps explain why investment levels vary across economic cycles.
1. Rate of economic growth
The overall rate of economic growth has a direct influence on investment levels.
In times of strong economic growth, firms experience rising sales and profits, which improves the expected return on new investment projects.
If firms anticipate sustained increases in demand, they are more likely to invest in expanding their productive capacity—by acquiring more capital equipment, opening new premises, or increasing staffing and infrastructure.
A positive feedback loop can develop: growth leads to more investment, which boosts future capacity and drives further growth.
Conversely, during economic downturns, investment often falls sharply as firms reduce costs and face reduced demand.
For instance, in the early 2010s, the UK saw sluggish investment as the economy struggled to recover from the financial crisis. In contrast, during periods of rapid growth—such as the early 2000s—UK firms expanded capital spending to meet rising consumer demand.
2. Business expectations and confidence
Investment is inherently forward-looking, meaning it depends not only on current conditions but also on firms’ expectations of the future.
If businesses are confident about future profits, they are more inclined to take risks and commit to investment projects.
A lack of confidence can delay or cancel investment, even if other conditions—such as low interest rates—are favourable.
Business confidence is influenced by:
Macroeconomic stability
Political certainty
Global market conditions
Clarity in government policy
Firms often rely on confidence indices such as the PMI (Purchasing Managers’ Index) or business sentiment surveys to gauge the broader environment.
For example, during the period surrounding the 2016 Brexit referendum, many UK firms delayed investment due to uncertainty about trade arrangements and regulatory changes.
3. Keynes’ concept of ‘animal spirits’
John Maynard Keynes introduced the concept of “animal spirits” to describe the role of psychological factors in driving economic decision-making.
“Animal spirits” refers to the emotional and instinctive side of business behaviour.
Investment decisions are not purely rational or data-driven. They are often based on gut feeling, optimism, or fear.
Even in situations where the economic case for investment is strong, a lack of psychological momentum can reduce investment.
Keynes argued that economic policy should account for this irrational behaviour, particularly in recessions when fear dominates business sentiment.
An example of this can be seen during speculative booms, such as the late-1990s tech bubble, where firms made massive investments based on enthusiasm rather than fundamentals. Conversely, following the 2008 crash, investment dried up as pessimism set in, despite government attempts to stimulate demand.
4. Demand for exports
Firms producing goods and services for international markets base part of their investment decisions on the strength of global demand.
A rise in demand for exports signals that foreign markets are growing, prompting firms to invest in order to expand output.
Export-oriented industries are highly responsive to international trade conditions and global growth trends.
This is particularly important in open economies like the UK, where a significant share of GDP comes from trade.
For example, when demand from the EU and Asia increases for British manufactured goods such as automotive components or aerospace parts, UK firms may invest in expanding production facilities.
Alternatively, trade restrictions, tariffs, or weakening demand in key export markets can reduce investment incentives.
5. Interest rates
Interest rates affect investment in two key ways:
Cost of borrowing: Most investment projects are financed through borrowing. Higher interest rates increase the cost of loans, making investment projects less attractive.
Opportunity cost of retained earnings: Firms that fund investment through their own profits will consider what returns they could earn elsewhere, such as in savings or other financial assets.
Therefore:
When interest rates are high, investment tends to fall.
When interest rates are low, borrowing is cheaper, encouraging firms to take out loans and invest.
The central bank, such as the Bank of England, sets the base rate, influencing commercial lending rates across the economy.
After the 2008 financial crisis, the Bank of England cut interest rates to historic lows to encourage firms to invest and stimulate the economy.
However, low interest rates do not guarantee investment. If firms are pessimistic or demand is weak, they may still hold back.
6. Access to credit
Interest rates are only part of the picture. Firms also need access to finance.
A firm may be willing to invest and able to afford the repayments, but if banks are unwilling to lend, investment cannot proceed.
After major financial crises, credit availability often contracts as lenders become risk-averse.
Smaller firms (SMEs) are especially vulnerable to credit constraints, as they have fewer assets to use as collateral.
In the years following the global financial crisis, many UK SMEs reported difficulty accessing bank loans, even when interest rates were low and investment was desirable.
Government initiatives, such as loan guarantee schemes or credit easing programmes, aim to bridge this gap.
Access to alternative financing, such as venture capital, crowdfunding, or angel investors, can also influence investment, particularly in high-growth or tech-focused industries.
7. Government policy and regulation
The government can use fiscal policy and regulatory changes to influence business investment directly or indirectly.
Taxes and investment incentives
High corporate tax rates reduce firms’ after-tax profits, lowering the incentive to invest.
Investment tax credits or accelerated depreciation allowances can boost investment by making capital purchases more tax-efficient.
These policies are often used to stimulate investment in priority sectors, such as renewable energy, digital infrastructure, or research and development.
In 2021, the UK government introduced a “super deduction” policy, allowing companies to deduct 130% of qualifying investment spending from their taxable income. This was designed to encourage capital investment as part of the post-pandemic recovery plan.
Regulation and bureaucracy
Complex or unpredictable regulations increase the cost and uncertainty of investment, particularly in sectors such as construction, energy, or finance.
Conversely, streamlined and transparent regulation reduces barriers and can promote greater capital spending.
Governments may also impose regulations that require investment—such as environmental standards—which compel firms to upgrade or replace capital equipment.
An example includes new environmental legislation requiring car manufacturers to invest in electric vehicle production capacity.
Real-life examples of investment dynamics
Understanding how the above influences interact in practice is essential for applying economic theory.
Policy-driven investment
Governments often use investment incentives as part of counter-cyclical fiscal policy.
During recessions, public sector investment in infrastructure (e.g., roads, railways, broadband) can create jobs and boost demand.
Simultaneously, tax cuts or allowances encourage the private sector to increase investment.
The UK government’s “Build Back Better” plan aimed to boost productivity by supporting infrastructure and R&D investment in response to the COVID-19 pandemic.
Such actions generate multiplier effects, where increased capital spending raises income and further boosts demand.
Confidence shocks
External events can cause rapid shifts in confidence, altering investment behaviour almost overnight.
Geopolitical instability, such as war or trade sanctions, undermines business confidence.
Natural disasters or pandemics introduce large-scale uncertainty.
Even positive developments, like a trade deal or new technology, can rapidly increase investment.
During the early months of the COVID-19 pandemic, UK firms suspended capital projects amid extreme uncertainty, despite record-low interest rates and government support. In contrast, the 2022 UK–India free trade agreement talks encouraged investment in export-oriented sectors due to anticipated market access.
FAQ
Low interest rates are generally expected to stimulate investment by reducing the cost of borrowing and lowering the opportunity cost of using retained earnings. However, in practice, investment may remain subdued despite low interest rates due to several factors. One major reason is low business confidence—if firms are uncertain about future demand, political conditions, or global economic stability, they may choose to delay or cancel investment plans. Excess capacity is another factor; if businesses are already operating below full capacity, they have little incentive to invest in expanding production. Additionally, tight credit conditions can restrict access to finance, especially for smaller firms, regardless of how low the interest rates are. Structural issues, such as a lack of skilled labour or poor infrastructure, can also act as deterrents. Finally, regulatory burdens or anticipated policy changes may cause firms to adopt a ‘wait and see’ approach, stalling investment activity.
Uncertainty can influence short-term and long-term investment decisions differently. In the short term, uncertainty may lead to a postponement of discretionary investments, such as the purchase of new machinery or expansion into new markets, because firms want to avoid making commitments under unstable conditions. Long-term investments—such as building a new factory or developing new technology—may still proceed if they are seen as strategic or unavoidable, but firms may demand a higher expected return to compensate for the risk. Sector-specific uncertainty, such as changes in regulation for energy firms or potential tariffs for exporters, can directly affect industry-specific investments. Additionally, uncertainty surrounding future tax policies or trade deals may prompt firms to diversify investments geographically or restructure operations rather than invest domestically. Overall, high uncertainty raises the cost of inaction but also the risk of poor outcomes, making firms more cautious in allocating capital.
Retained profit refers to the portion of a firm's net income that is not distributed as dividends but kept within the business for reinvestment. It plays a crucial role in financing investment because it allows firms to fund projects without incurring debt or issuing new equity. This reduces exposure to interest payments and avoids dilution of ownership. Using retained profits is often faster and more flexible, as it does not require formal approval from banks or investors. Firms prefer it particularly when external finance is expensive or difficult to obtain, such as during credit crunches. Moreover, using internal funds signals financial stability to stakeholders and avoids the potential reputational risk of overreliance on borrowing. However, retained profit is only available if a firm is consistently profitable, and for large-scale investments, it may not be sufficient. In such cases, firms might combine retained profits with external finance to meet capital requirements.
While investment is a component of aggregate demand in the short run, its more profound impact lies in its contribution to long-term economic growth through supply-side improvements. Capital investment increases the productive capacity of the economy by enhancing the quantity and quality of capital stock. For example, newer machines and technology improve labour productivity, leading to more output with the same or fewer inputs. Infrastructure investment—such as in transport or digital connectivity—reduces costs and time delays, making firms more efficient. Investment in research and development (R&D) leads to innovation, creating new products and improving processes, thereby raising the potential output of the economy. Over time, sustained investment shifts the long-run aggregate supply (LRAS) curve to the right, reflecting an increase in the economy’s ability to produce. This underpins sustainable growth, supports higher employment levels, and can improve living standards through higher real incomes and more choices for consumers.
Government policy can play a key role in addressing market failures that lead to underinvestment, particularly in sectors where private returns are lower than social returns. For example, firms may underinvest in education, healthcare, green technologies, or infrastructure, as these areas often generate widespread societal benefits that are not fully captured by the investing firm. To correct this, governments can provide subsidies or tax incentives to encourage private sector investment in targeted sectors. Public-private partnerships (PPPs) can also be used to share risk and leverage private capital for socially beneficial projects. Additionally, the government can directly invest in public goods or create a more favourable business environment by improving the legal system, reducing red tape, or stabilising macroeconomic conditions. In some cases, regulations may be introduced to mandate certain types of investment, such as environmental standards requiring investment in cleaner technology. Overall, well-designed policy can align private incentives with social welfare, encouraging more efficient levels of investment.
Practice Questions
Explain two factors that might influence a firm's decision to invest.
One key factor is interest rates. Lower interest rates reduce the cost of borrowing, making investment projects more affordable and increasing the likelihood of firms investing. They also lower the opportunity cost of using retained earnings. Another important factor is business confidence. If firms expect strong future demand and economic stability, they are more likely to invest in expanding capacity. Conversely, uncertainty or pessimism about future market conditions may cause firms to delay or cancel planned investment, even if other factors such as interest rates are favourable.
Evaluate the likely impact of a fall in business confidence on investment and aggregate demand in the UK.
A fall in business confidence is likely to reduce investment as firms become more cautious about future profitability. Lower investment means less spending on capital goods, decreasing aggregate demand (AD). This can lead to slower economic growth and potentially higher unemployment. However, the extent of the impact depends on other factors such as interest rates and government policy. If monetary or fiscal policy is expansionary, it could offset the decline in business confidence. Moreover, not all sectors are equally affected, so while aggregate investment may fall, some industries could maintain spending due to long-term contracts or obligations.
