Unit 9.3 Investment and the Economy

Learning objectives

Explain how investment affects aggregate demand.

2. Explain how investment affects economic growth.

We shall examine the impact of investment on the economy in the context of the model of AD and AS. Investment is a component of AD; changes in investment shift the AD curve by the amount of the initial change times the multiplier. Investment changes the capital stock; changes in the capital stock shift the production possibilities curve and the economy’s aggregate PF and thus shift the long- and short-run aggregate supply curves to the right or to the left.

Investment and Aggregate Demand

In the short run, changes in investment cause AD to change. Consider, for example, the impact of a reduction in the interest rate, given the investment demand curve (ID). In Figure A Change in Investment and Aggregate Demand, Panel (a), which uses the investment demand curve introduced in Figure The Investment Demand Curve, a reduction in the interest rate from 8% to 6% increases investment by $50 billion per year. Assume that the multiplier is 2. With an increase in investment of $50 billion per year and a multiplier of 2, the AD curve shifts to the right by $100 billion to AD ₂ in Panel (b). The quantity of real GDP demanded at each price level thus increases. At a price level of 1.0, for example, the quantity of real GDP demanded rises from $8,000 billion to $8,100 billion per year.

Figure A Change in Investment and Aggregate Demand

 

A reduction in investment would shift the AD curve to the left by an amount equal to the multiplier times the change in investment.

The relationship between investment and interest rates is one key to the effectiveness of monetary policy to the economy. When the Fed seeks to increase aggregate demand, it purchases bonds. That raises bond prices, reduces interest rates, and stimulates investment and aggregate demand as illustrated in Figure A Change in Investment and Aggregate Demand. When the Fed seeks to decrease aggregate demand, it sells bonds. That lowers bond prices, raises interest rates, and reduces investment and aggregate demand. The extent to which investment responds to a change in interest rates is a crucial factor in how effective monetary policy is.

Investment and Economic Growth

Investment adds to the stock of capital, and the quantity of capital available to an economy is a crucial determinant of its productivity. Investment thus contributes to economic growth. We saw in Figure The Choice between Consumption and Investment that an increase in an economy’s stock of capital shifts its PPC outward. That also shifts its LRAS curve to the right. At the same time, of course, an increase in investment affects AD, as we saw in Figure A Change in Investment and Aggregate Demand.

Key concepts

· Changes in investment shift the aggregate demand curve to the right or left by an amount equal to the initial change in investment times the multiplier.

· Investment adds to the capital stock; it therefore contributes to economic growth.

 

Multiple Choice Test

Net investment is:

a) non-production costs;

b) money spent by the population;

c) gross investments minus taxes;

d) gross investment minus depreciation.

Numerical tasks

1. If the savings function is described by the formula S = -30 + 0.1 Y, and the autonomous investment is 125. What will the equilibrium level Y be?  

2. In the economy, the investment function is determined by the equation I = 40 + 0,4 Y, and the function of savings is demonstrated by the equation S = -20 + 0.6 Y, where Y is national income, and the investments equal savings. Determine the equilibrium level of national income.

 

Chapter 10. Net Exports and International Finance

Unit 10.1 The International Sector: An Introduction

Learning objectives