13.3 Investment and Aggregate Supply

Macroeconomics / Rudiger Dornbusch - HB171.5 .D619 2006

13.3 Investment and Aggregate Supply

Investment is an important component of AD. Investment also increases capital, increasing the productive capacity of the economy. In the short run, investment does not matter for AS but in the long run it does. A little back-of-the-envelope arithmetic can help us to make sense of this apparent contradiction.

We saw in Insight 13.1 that a year’s worth of investment is typically about 1/15 of the capital stock. Suppose someone found a policy to increase investment by 25 per cent more than it would otherwise have grown. (The historical record suggests that no one has come up with an idea nearly this effective – but hope springs eternal!) Over the course of a year the effect of the policy would be to increase capital by about 1/60 extra, or about 1.6 percent. Looking back at what we learned about growth accounting in C3, this would translate into an increase in GDP of about 4/10 of 1 per cent. The notion that short-run policy might increase investment by 25 percent is probably outlandish. The short-run supply side effect of any realistic policy will probably be too small to measure.

While the short-run supply-side effects of stimulating investment are likely to be quite limited, increasing investment may be among the most important tools for long-tem prosperity. The effect of modest annual increases in the capital stock can accumulate to be quite large over long periods. We can see the evidence for this by looking at the very high rates of investment as countries move into modern development, with very high rates of growth sustained for considerable periods.

Investment and government

This chapter has concerned itself with private investment. We should, however, make a few brief comments concerning the importance of public investment. In particular, economists are often concerned about the consequences of short-run crowding out of private investment by government budget deficits, which are assumed to mostly fund government consumption expenditure.

However, recent developments in the theory of FP have begun to focus on the importance of government investment behavior in determining private sector investment performance. A traditional responsibility of government is to supply mush of the economy’s basic infrastructure, which largely takes the form of the provision of public goods that the private sector would not otherwise provide. It is quite possible that private business will be more likely to make more profitable investments in an economy that has large quantity of high-quality infrastructure, much of which may need to be provided by the government. By this we mean public infrastructure such as the transport infrastructure (for example, roads, railways and airports), the communications infrastructure (such as telephone cables) and the social infrastructure (such as schools, universities and the legal system).

In light of this positive relationship between private and public investment, perhaps we should be concerned about the decline in public investment expenditure in Australia, which has fallen from around 7 per cent of GDP in the 1960s and 1970s to around 4 percent of GDP today. Figure 13.20 (see ABS Time Series Statistic Plus, National Accounts Database, in dX Database) illustrates this decline. The suggestion could be that governments that tend to secure balanced budgets, or fiscal surpluses, by cutting public investment rather than public consumption, might in fact still be crowding out some private investment.

On the other hand, what we have seen around the world in the last 30 years is a shift towards private provision of many forms of infrastructure. Governments have devolved themselves of activities that were formerly assumed to be best provided by government, but are now assumed to be efficiently provided by the private sector – for example, the private provision of tool roads, the building of new airports and the renovation of old ones, and the move towards private education.

Nevertheless, certain types of public infrastructure investment are likely to be extremely important in facilitating private investment and driving long-run economic growth. The mix between government consumption and government investment in any FP changes that occur is something we should recognize as important.

Investment around the world

One reason that high-growth countries are high-growth countries is because they devote a substantial fraction of their output of investment. Table 13.3 shows the ratio of gross fixed capital formation of GDP to several countries. The investment ratios are determined by both the demand of capital, as studied in this chapter, and the supply of savings.

Table 13.3 Ratio of investment of GDP (%)
Country	1975	2002
Australia	22.1	24.1
NZ	19.3	20.3
US	17.6	18.2
Canada	24.4	19.6
Japan	32.5	25.6
Korea	24.9	26
Singapore	35.1	20.6
Bangladesh	5.5	23.1
Ethiopia	5.5	20.5

Source: International Financial Statistics Yearbook, 2003 and the World Bank World Tables in dX Database (ratio of total gross fixed capital formation to GDP)

Table 13.3 suggests that high rates of investment occur in rapidly growing countries but not necessarily in countries that have already become very wealthy. In both 1975 and 2002, Australia and NZ were wealthy countries with moderate growth rates. In 1975, Japan was a moderately well off country with a high growth rate. Over this period, both Singapore and Korea grew very rapidly, due in part of their high rates of investment, but Bangladesh and Ethiopia, had investment rates too low to support rapid growth. By 2002, although both countries remained relatively poor, their investment rates had picked up considerably.

The relatively low rates of investment in Australia, NZ, US and Canada, compared with their international competitors, is a source of long-run concern to policy makers.