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(a) What are the determinants of investment expenditure?
[10]
(b) How would an increase in investment expenditure affect n...
investments, technological advancements and an increase in the availability of credit will
also lead to an increase in inv...
Approach 1
(b)
National income is the total income earned by the nation over a period of time.
The effect of an increase i...
Round
1
2
3
‘
‘
‘
Sum

Y
$1000
$800
$640
‘
‘
‘
$5000

CD
$800
$640
‘
‘
‘
‘
$4000

W
$200
$160
‘
‘
‘
‘
$1000

In the abo...
In the above diagram, when aggregate demand (AD) rises from AD0 to AD1, national
income (Y) rises by less than the full mu...
an increase in investment expenditure will lead to a more rapid increase in the production
capacity in the economy and hen...
Approach 2
(b)
National income is the total income earned by the nation over a period of time.
The effect of an increase i...
Round
1
2
3
‘
‘
‘
Sum

Y
$1000
$800
$640
‘
‘
‘
$5000

CD
$800
$640
‘
‘
‘
‘
$4000

W
$200
$160
‘
‘
‘
‘
$1000

In the abo...
In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to
an increase in national income (Y) fro...
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Q.23 determinants-of-investment-investment-and-national-income

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Transcript of "Q.23 determinants-of-investment-investment-and-national-income"

  1. 1. (a) What are the determinants of investment expenditure? [10] (b) How would an increase in investment expenditure affect national income? [15] (a) Investment expenditure is the expenditure made by firms on goods produced not for their present use but for their use in the future. When discussing the determinants of investment expenditure, it is useful to distinguish between autonomous investment and induced investment as they have different determinants. Autonomous investment is the part of investment that does not depend on national income and is determined by interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. A fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure and vice versa. The investment function shows the investment expenditure of firms at each interest rate. According to the marginal efficiency of investment theory, the marginal efficiency of investment function is the investment function. An increase in investment expenditure due to a fall in interest rates can be shown by a downward movement along the marginal efficiency of investment function. In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downward movement along the marginal efficiency of investment function (MEI) resulting in an increase in investment expenditure (I) from I0 to I1. In addition to a fall in interest rates, the number of profitable planned investments and hence investment expenditure will also increase when expected returns on planned investments increase due to stronger business sentiment, lower business costs such as decreases in oil prices and wages or lower capital costs such as decreases in the costs of factories and machinery. Further, a decrease in corporate income tax which will increase expected after-tax returns on planned © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  2. 2. investments, technological advancements and an increase in the availability of credit will also lead to an increase in investment expenditure. An increase in investment expenditure due to a non-interest rate factor can be shown by a rightward shift in the marginal efficiency of investment function. In the above diagram, a rightward shift in the marginal efficiency of investment (MEI) function from MEI0 to MEI1 leads to an increase in investment expenditure (I) from I0 to I1 at the same interest rate (r0). Induced investment is the part of investment that depends on national income. According to the accelerator theory of investment, net investment is determined by the rate of change of national income. When national income rises at an increasing rate, net investment will increase. However, when national income rises at a decreasing rate, net investment will decrease. The size of the accelerator effect depends on the capital-output ratio. The higher the capital-output ratio, the larger the accelerator effect. For instance, due to the high capital-output ratio in the United States, the accelerator effect is large. In conclusion, investment expenditure is a volatile component of aggregate demand. Therefore, the government should control investment expenditure to maintain the good health of the economy. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  3. 3. Approach 1 (b) National income is the total income earned by the nation over a period of time. The effect of an increase in investment expenditure on national income will depend on the size of the multiplier and the initial state of the economy. An increase in investment expenditure will lead to an increase in aggregate demand and hence national income, other things being equal. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. In the above diagram, an increase in aggregate demand and hence aggregate expenditure (AE) from AE0 to AE1 leads to an increase in national income (Y) from Y0 to Y1. Further, due to the multiplier effect, the increase in national income is larger than the initial increase in aggregate demand. Suppose that the marginal propensity to consume domestic goods and services (MPCD) is 0.8, the marginal propensity to withdraw (MPW) is 0.2 and the increase in aggregate demand is $1000. When aggregate demand rises by $1000, firms will employ more factor inputs to produce more output and hence pay more factor income to households. Household income and hence consumption expenditure will rise by $1000 and $800 (0.8 × $1000) respectively. Due to the increase in consumption expenditure of $800, firms will employ even more factor inputs to produce even more output and hence pay even more factor income to households. Household income and hence consumption expenditure will rise further by $800 and $640 (0.8 × $800) respectively. However, each time household income rises, savings, taxes and imports will rise, and when these withdrawals have increased by $1000 to the level that matches injections, equilibrium will be restored and national income will stop rising. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  4. 4. Round 1 2 3 ‘ ‘ ‘ Sum Y $1000 $800 $640 ‘ ‘ ‘ $5000 CD $800 $640 ‘ ‘ ‘ ‘ $4000 W $200 $160 ‘ ‘ ‘ ‘ $1000 In the above table, the increase in national income of $5000 is greater than the initial increase in aggregate demand of $1000. Since the multiplier is the inverse of the MPW, it will be larger the lower the savings, the lower the income taxes and the lower the imports. If there is initially a lot of excess production capacity in the economy, the increase in aggregate demand will not lead to a rise in the general price level and hence national income will rise by the full multiplier effect. In the above diagram, when aggregate demand (AD) rises from AD0 to AD1, national income (Y) rises by the full multiplier effect from Y0 to Y1. The general price level (P) remains at P0. If there is initially some, but not a lot of, excess production capacity in the economy, the increase in aggregate demand will lead to a rise in the general price level and hence national income will not rise by the full multiplier effect. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  5. 5. In the above diagram, when aggregate demand (AD) rises from AD0 to AD1, national income (Y) rises by less than the full multiplier effect from Y0 to Y1. The general price level (P) rises from P0 to P1. If there is initially no excess production capacity in the economy, the increase in aggregate demand will only lead to a rise in the general price level without having any effect on national income. In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to a rise in the general price level (P) from P0 to P1. National income (Y) remains at Y0. However, if the production capacity in the economy and hence aggregate supply is increasing, which is the normal state of the economy, national income will rise. Indeed, © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  6. 6. an increase in investment expenditure will lead to a more rapid increase in the production capacity in the economy and hence aggregate supply in the long run. In the final analysis, an increase in investment expenditure is desirable for the economy as it will lead to higher economic growth both in the short run and in the long run, and this is the reason why many governments around the world have been cutting corporate income tax to attract foreign direct investments. However, although a rapid increase in investment expenditure will lead to lower inflation in the long run, it may cause the economy to overheat in the short run. Further, an increase in investment expenditure may not lead to an increase in aggregate demand as it may be offset by a decrease in the other components, and this could happen as investment expenditure is small component of aggregate demand in many economies. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  7. 7. Approach 2 (b) National income is the total income earned by the nation over a period of time. The effect of an increase in investment expenditure on national income will depend on the size of the multiplier and the initial state of the economy. An increase in investment expenditure will lead to an increase in aggregate demand and hence national income, other things being equal. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. In the above diagram, an increase in aggregate demand and hence aggregate expenditure (AE) from AE0 to AE1 leads to an increase in national income (Y) from Y0 to Y1. Further, due to the multiplier effect, the increase in national income is larger than the initial increase in aggregate demand. Suppose that the marginal propensity to consume domestic goods and services (MPCD) is 0.8, the marginal propensity to withdraw (MPW) is 0.2 and the increase in aggregate demand is $1000. When aggregate demand rises by $1000, firms will employ more factor inputs to produce more output and hence pay more factor income to households. Household income and hence consumption expenditure will rise by $1000 and $800 (0.8 × $1000) respectively. Due to the increase in consumption expenditure of $800, firms will employ even more factor inputs to produce even more output and hence pay even more factor income to households. Household income and hence consumption expenditure will rise further by $800 and $640 (0.8 × $800) respectively. However, the multiplier process will not go on forever because each time household income rises, savings, taxes and imports will rise, and when these withdrawals have increased by $1000 to the level that matches injections, equilibrium will be restored and national income will stop rising. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  8. 8. Round 1 2 3 ‘ ‘ ‘ Sum Y $1000 $800 $640 ‘ ‘ ‘ $5000 CD $800 $640 ‘ ‘ ‘ ‘ $4000 W $200 $160 ‘ ‘ ‘ ‘ $1000 In the above table, the increase in national income of $5000 is greater than the initial increase in aggregate demand of $1000. Since the multiplier is the inverse of the MPW, it will be larger the lower the savings, the lower the income taxes and the lower the imports. In reality, when aggregate demand rises, national income will not rise by the full multiplier effect due to a rise in the general price level. If the economy is initially at a below-full-employment equilibrium, national income will stay at the higher level, assuming the increase in aggregate demand exactly closes the negative output gap. In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national income (Y) from Y0 to Y1  Yf, exactly closing the negative output gap (Y0 – Yf), where Yf is the full-employment national income. Other things being equal, national income will stay at Y1. If the economy is initially at the full-employment equilibrium, the increase in aggregate demand will lead to a positive output gap and hence national income will fall back to the initial level. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  9. 9. In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national income (Y) from Y0  Yf to Y1, creating a positive output gap (Y1 – Yf). When national income is above the full-employment level, unemployment will be below the natural rate. In such a state of the economy, firms will find it difficult to employ workers but workers will find it easy to get jobs which will lead to an upward pressure on factor prices. When factor prices and hence the cost of production in the economy rise in the long run, aggregate supply (AS) will fall from AS0 to AS1 and hence national income will fall back to Y0  Yf. However, if the production capacity in the economy and hence aggregate supply is increasing, which is the normal state of the economy, national income will not fall back to the initial level. Instead, it will tend towards the new full-employment level, which may be even higher than Y1. Indeed, an increase in investment expenditure will lead to a more rapid increase in the production capacity in the economy and hence aggregate supply in the long run. In the final analysis, an increase in investment expenditure is desirable for the economy as it will lead to higher economic growth both in the short run and in the long run, and this is the reason why many governments around the world have been cutting corporate income tax to attract foreign direct investments. However, although a rapid increase in investment expenditure will lead to lower inflation in the long run, it may cause the economy to overheat in the short run. Further, an increase in investment expenditure may not lead to an increase in aggregate demand as it may be offset by a decrease in the other components, and this could happen as investment expenditure is small component of aggregate demand in many economies. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek

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