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

1048 Words Jan 25th, 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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Because we live in a world without perfect information, business’ expectation is the driving factor behind the level of capital held in order to obtain optimal cash flows, which can often result in adverse selection or a self-fulfilling-prophecy.
The years up to 2008 were economically strong for Western economies and it stands to reason that investors believed this would continue. Of course this expectation of high levels of future demand for their output resulted in their accumulated capital being greater than if they were expecting the credit crisis and global recession which were to follow. When the realisation that there was to be the biggest recession since the Great Depression hit, the firms inevitably updated their beliefs on the present value of future cash flows and found that a proportion of accumulated capital would generate a loss due to lower demand causing revenue to fall. The convexity of the marginal-revenue-product of capital with positive, diminishing returns suggests that firms would reduce their accumulated capital until no longer loss making. It is now possible to incorporate investment.
Investment is one of the three factors of output within a closed economy. It can be Business, Residential and Inventory investment, increasing in volatility. The optimal investment in a given period depends upon the real user cost of capital, expected shadow-price of capital and the adjustment costs, costs that increase greater
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