What has been the role of business investment in contributing to GDP growth in the UK To see more of our products visit our website at Ian Black, Head of Economics, St Albans School

Definitions 1 Business investment measures expenditure on fixed capital by manufacturing and non manufacturing businesses within the UK. Fixed capital is the stock of buildings, such as factories, offices and machinery. Business investment includes investment by both private and public (state) corporations. The other types of investment in the national accounts are government investment and investment by public and private corporations in dwellings.

Definitions 2 Added together the four components of investment give the net addition to the capital stock in the UK. Overall, business investment has been weak in recent years, largely due to a lack of business confidence. This is known as Gross Fixed Capital Formation. Business investment is by far the largest component of Gross Fixed Capital Formation. So, changes in business investment will usually drive changes in Gross Fixed Capital Formation.

Theory Economic growth is determined by the change in the amount of resources available and the productivity of those resources. A rise in the economy’s fixed capital stock will increase the number of resources in the economy. Since successful investment raises both the quantity and the quality of resources in the economy it is often seen as the key to growth. G It is often difficult to work out the causation between variables, but causation goes both ways in the case of investment and GDP. C Changes in investment will lead to changes in GDP, while changes in GDP will cause changes in investment. C

A change in investment leading to a change in GDP 1 In the short term a rise in business investment will increase aggregate demand. C Investment is a component of aggregate demand (AD), since AD = C + I + G + X – M. C Investment is an injection into the circular flow of income, so a rise in investment will lead to a multiplied rise in GDP. C The size of the final change in real GDP will be determined by the size of the multiplier and the size of the initial investment. C

A change in investment Leading to a change in GDP 2 This is what economists strictly mean by economic growth. C Over the long term investment will increase the productive potential of the economy and shift the PDF to the right. C A rise in investment leads to a shift in the AD curve to the right, causing a rise in the equilibrium level of real output. C In terms of the AD/AS model, investment leads to a rise in long run aggregate supply. C We should expect that increased business investment would lead to both a short term rise in the level of real GDP and a rise in economic growth. C

A change in GDP leading to a change in investment The accelerator theory suggests that it is changes in GDP that determine changes in the level of fixed capital investment. C Assuming businesses are running at full capacity, a rise in demand for products will lead to a rise in the amount of fixed capital required to make those products. C The theory suggests that changes in investment will be more volatile than changes in GDP. C This is because the percentage rise in machines will likely be greater than the percentage rise in demand for products. C

The empirical evidence 1 It is not just the quantity of investment that is important but also the quality. C The UK appears to have improved the efficiency of its investment since the 1990s. C In 2011 fixed capital investment accounted for 15% of UK GDP in real terms, while business investment accounted for 8.3% of GDP C However, investment is a more important component of aggregate demand than these shares suggest. C

The empirical evidence 2 Investment is highly volatile, much more so than GDP. C It is often changes in investment that drive changes in real GDP. C To establish whether changes in investment contribute to changes in GDP we should compare the changes in both variables over time. C Over the last 6 years, when plotted against each other, a relationship can be seen between business investment and GDP. C The collapse in business investment in is surely part of the reason for the collapse in real GDP. C

The empirical evidence 3 We need to know what has happened to changes in other components of GDP to assess the contribution of investment. C The data shows that from the biggest contributor to changes in UK real GDP was consumer spending, with many arguing that the UK relied too heavily on consumer spending during this period. C But investment made an equal contribution to growth with consumer spending in 2007, providing some evidence for the accelerator hypothesis. C We would expect investment to rise because of economic growth and businesses hitting capacity constraints in a boom and for investment to make the greatest contribution to real GDP growth. C

The empirical evidence 4 The main reason for the fall in GDP in 2008 and 2009 is the fall in investment. C This is again consistent with the accelerator, suggesting that investment growth will collapse during a period of recession. Investment also makes the biggest contribution to growth in C However, the biggest (positive) contributor to real GDP growth in 2009 and 2011 is net trade. C This was partially due to the relatively low value of the pound in relation to foreign currencies, which made UK exports relatively price competitive. C

Conclusion 1 Business investment plays a crucial role in contributing to GDP growth. C However, it has not always made as large a contribution as other components of GDP. C This is because the UK has often relied too heavily on consumer spending. C Recent evidence suggests that a rebalancing of the economy towards investment and exports is underway. C

Conclusion 2 Some government policies such as recent cuts in corporation tax may boost business investment. C The British Chamber of Commerce is forecasting a strong recovery in business investment for C However, the uncertainty surrounding the UK and the global economy and the alleged unwillingness of banks to lend money to businesses, seem to be acting as constraints on business investment in the future. C