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INVESTMENT SPENDING

The term investment, as you saw in Chapter 10, refers to spending by businesses on capital goods—factories, machinery, and other aids to production. Investment spending has a dual influence on the economy. First, as a major component of total spending, investment spending helps determine the economy's level of total output and total employment. Second, investment is a critical determinant of the economy's rate of growth. We define economic growth as an increase in the economy's productive capacity or potential GDP. Investment spending contributes to economic growth because it enlarges the economy's stock of capital goods and thereby helps increase the economy's capacity to produce goods and services.

The Determinants of Investment

Profit expectations are the overriding motivation of all investment-spending plans in a market economy. Those expectations are based on a comparison of costs and revenues.

Suppose you are considering investing in a soft-drink machine for the lobby of the student union. How do you decide whether to make the investment? Like any other businessperson, you compare costs and revenues. On the cost side, you consider the price of the machine and the interest charges on the money you would have to borrow to buy it. If you would be using your own money, you consider the opportunity cost of those funds—the amount of interest you will sacrifice if you withdraw that money from your savings to purchase the machine. On the revenue side, you would include the expected income from selling the soft drinks minus the cost of the drinks. If you expect the machine to generate revenues exceeding all your anticipated costs, you have incentive to make the investment. If not, the investment should not be made. All investment decisions involve a similar comparison.

 
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