No Such Thing as a Free Lunch: Principles of Economics (Part 155)

Economics is not a science; it is a quasi-religion: part superstition, part mystique, part sentimentality. Bankers dream like other men, the only difference being that when their dreams turn to nightmares, we all lose sleep. There can be no trusting the muttering of any prelate when it comes to money.

Howard Jacobson

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part E)

by

Charles Lamson

Expectations and Animal Spirits

In addition to the cost of capital and the cost of labor, expectations about the future play a big role in investment and employment decisions.

Time is a key factor in investment decisions. A developer who decides to build an office tower is making an investment that will be around (barring earthquakes, floods, or tornadoes) for several decades. In deciding where to build a plant, a manufacturing firm is committing a large amount of resources to purchase capital that will presumably yield services over a long time. Furthermore, the decision to build a plant or to purchase large equipment must often be made years before the actual project is completed. While the acquisition of a small business computer may take only a few days, the planning process for downtown developments in large U.S. cities has been known to take decades.

For these reasons, investment decisions require looking into the future and forming expectations about it. In forming their expectations, firms consider numerous factors. At a minimum, they gather information about the demand for their specific product, about what their competitors are planning, and about the macroeconomy's overall health. A firm is not likely to increase its production capacity if it does not expect to sell more of its product in the future. Hilton will not put up a new hotel if it does not expect to fill the rooms at a profitable rate. Ford will not build a new plant if it expects the economy to enter a long recession.

Forecasting the future is fraught with dangers. Many events cannot be foreseen. Investments Are therefore always made with imperfect knowledge. John Maynard Keynes pointed this out in 1936:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the city of London amounts to little and sometimes nothing.

Kane's concludes from this that much investment activity depends on psychology and on what he calls the animal spirits of entrepreneurs:

Our decisions . . . can only be taken as a result of animal spirits. In estimating the prospect of investment, we must have regard, therefore, to nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends. [John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), pp. 149, 152]

Because expectations about the future are, as Keynes points out, subject to Great uncertainty, they may change often. The animal spirits help to make investment a volatile component of GDP.

The Accelerator Effect Expectations, at least in part, determine the level of planned investment spending. At any interest rate, the level of investment is likely to be higher if businesses are optimistic. If businesses are pessimistic, the level of planned investment will be lower, but what determines expectations?

One possibility born out empirically is that expectations are optimistic when aggregate output (Y) is rising and pessimistic when aggregate output is falling.

At any given level of the interest rate, expectations are likely to be more optimistic and planned investment is likely to be higher when output is growing rapidly than when it is growing slowly or falling.

It is easy to see why. If firms expect future output to grow, they must plan now to add productive capacity. One indicator of future prospects is the current growth rate.

If this is the case in reality, and evidence indicates it is, the ultimate result will be an accelerator effect. If aggregate output (income) (Y) is rising, investment will increase even though the level of Y may be low. Higher investment spending leads to an added increase in output, further "accelerating" the growth of aggregate output. If Y is falling, expectations are dampened, and investment spending will be cut even though the level of Y may be high, accelerating the decline. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 618-620*

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