Investment Theory Is Unsatisfactory Because Too Little Attention Is Paid to Business Expectations and Unless You Do This It Is Hard to Explain What Happened to Investment Rates in Many Western Economies Since 2008

1062 Words Feb 18th, 2013 5 Pages
“Investment theory is unsatisfactory because too little attention is paid to business expectations and unless you do this it is hard to explain what happened to investment rates in many Western economies since 2008.” Discuss.
In this essay I will describe the key aspects behind the basic neoclassical model of investment and explain how it can be considered a satisfactory model, sufficient in explaining the changes in the investment rates since 2008 of Western economies. I will then develop the discussion further to include other elements of investment theory, such as cost adjustments and investment irreversibility, showing that it would indeed be difficult to explain the investment rates.
The basic neoclassical investment models all
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In a situation where there is an unexpected positive demand shock, by forgoing the revenue that would have been generated by additional capital below the optimum level of capital, the investor can increase the NPV by spreading the required investment to reach optimal accumulated capital over a number of periods, avoiding high adjustment costs. Adjustment costs are realistic and help to avoid theoretical situations in which a corner-shop becomes a multinational retailer in a single period if the NPV of being a multinational is higher than a corner-shop’s.
Investment can also be seen as the level of accumulated capital in a given period, subtracting the depreciated capital of the previous period. For example, if capital in period1 equals period0, the investment in period0 must be equal to depreciated capital during period0. It is possible to have a negative figure which is reversing an investment. We assume there is a “time-to-build” of 1 period to convert an investment in to usable capital.
It is therefore likely that a negative demand shock such as the one that began in 2008 not only causes investment to fall but makes it negative, significantly reducing aggregate investment. Contrary to the assumption that business expectation is being given little attention, it and its inherent inaccuracy appear to be among the key drivers of investment and its volatility. Governments can try to curtail this by

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