Investment: Driver of Cyclicality
GDP, the measure of the nation’s income, is the sum of 4 components:
Y (GDP) = C (Consumption) + I (Investment) + G (Government Spending) + (X [Exports] – M [Imports])
The most volatile component is investment. The cyclical variation of the economy could be said to largely be driven by investment.
We put Gross Private Domestic Investment in a vector autoregression framework with Real GDP, and ran an Impulse Response Function analysis on it to measure the impact of of the marginal change in investment on the real economy.
The answer was interesting: for every 1% y/y increase in nominal investment, real growth increased by 1% y/y by for several quarters after, the effect falling to 0 (and, roughly equilibrium) after 6 quarters.
Given GDP averages 6.39x the size of investment, investment wields substantial leverage over the economy. The equilibrium is achieved when the investment is simply rolled into future real GDP. The real capital has been created, and the means to utilise it have been pre-spent into the economy.
We should probably pause and define investment. Deploying capital to stocks or bonds isn’t investment – rather, it is simply allocation of savings. Investment activity either creates un-sold consumables (inventory stock), or increases the real capital stock (houses, machines, factories).
What incentivises investment?
The answer is simple: the expectation that there will be demand for the output resulting from the investment. That expectation is established from realised demand. That is: demand begets investment, which begets more demand.
Investment in the business cycle
A recession could potentially be characterised by the preference for liquidity (saving) over investment or consumption. What is rational for individual actors is not necessarily rational for the aggregate.
Counter-cyclical spending stablises aggregate demand, the anchor to which marginal investment decisions are made from.
At the same time, gross capital formation provides support in activity with consumption of fixed capital. Despite a downturn in economic activity, as long as the expectation isn’t for a prolonged depression and permanent output impairment, capital goods are replaced when worn out.
Thus are the evident levers of power over the economy.