Question

Why is investment spending unstable?

Short answer

Investment spending is highly volatile because of the variability in expectations, irregular innovations, the durability of capital goods, and volatility of present profits.

Step-by-step solution

Volatility in investment spending because of expectations

Firms invest only when they expect favourable situations for their business. This determines the level of profits.When a firm expects favourable conditions in the future, it will try to take advantage of this and increase investment spending. If the same firm expects unfavourable conditions, it will try to reduce its losses in the future and decrease investment spending.

The future conditions are very volatile. They depend on situations like war, trade barriers, exchange rates fluctuations, political influences, constitutional laws, court jurisdictions, natural disasters, and others. All these factors influence investment decisions.

Volatility caused by the irregular innovations

Innovations have strong power to determine the profit levels of the businesses. An innovation increases efficiency and yields a higher level of profits.However, innovations occur very rarely. It takes time to come up with new inventions or discoveries.

Thus, when innovation occurs, the investment rises all of a sudden but eventually lowers after some time.

Volatility caused by the durability of capital goods

The durability of capital goods decides the frequency of investment. If the capital goods do not require replacement or maintenance and can be used for a longer time, firms do not invest in the capital goods, while the less durable goods require the firms to invest more frequently.

Present profit influence over investment

Present profits spread a sentiment regarding the future expectation from the business. If a business is giving lower returns today, it is generally expected to yield lower returns in the future also. The pessimistic sentiments related to the expected rate of return lower the investment and vice versa. Thus, the present profits make investment more unstable.