Question

1. Which concept would you use to explain why investment spending did not grow strongly between 2011 and 2014 although interest rates were very low? Think about what drives investment spending and use a certain principle we covered in the chapter titled [Income and Expenditure] ( Around150 words)

Answer 1

Keynesian concept

Keynesian economics is an economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed by the British economist John Maynard Keynes during the 1930s in an attempt to understand the Great Depression. Keynes advocated for increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the depression.

Keynesian economics focuses on demand-side solutions to recessionary periods. Lowering interest rates is one way governments can meaningfully intervene in economic systems, thereby generating active economic demand. Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy. Wages and employment, they argue, are slower to respond to the needs of the market and require governmental intervention to stay on track.

Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging businesses and individuals to borrow more money. When borrowing is encouraged, businesses and individuals often increase their spending. This new spending stimulates the economy. Lowering interest rates, however, does not always lead directly to economic improvement.

Keynesian economists focus on lower interest rates as a solution to economic woes, but they generally try to avoid the zero-bound problem. As interest rates approach zero, stimulating the economy by lowering interest rates becomes less effective because it reduces the incentive to invest rather than simply hold money in cash or close substitutes like short term Treasuries. Interest rate manipulation may no longer be enough to generate new economic activity if it cannot spur investment, and the attempt at generating economic recovery may stall completely. This is a type of liquidity trap.

Liquidity trap

A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest.

Investment Spending

Investment spending refers to money spent on capital goods or goods used in the production of capital goods or services. Investment spending includes, purchases such as machinery, land , production inputs, and infrastructure. Investment spending should not be confused with investment, which refers to the purchase of financial instruments such as stocks, bonds, and derivatives. Also called capital formation.

Lower interest rates encourage additional investment spending, which gives the economy a boost in time of slow economic growth.

For example :- The Federal Reserve Board, also referred to as "the Fed," is in charge of setting interest rates for the United States through the use of monetary policy. The Fed adjusts interest rates to affect demand for goods and services. Interest rate fluctuations can have a large effect on the stock market, inflation, and the economy as a whole. Lowering interest rates is the Fed's most powerful tool to increase investment spending in the U.S. and to attempt to steer the country clear of recessions.

Driving force of investment spending

• Interest rates (the cost of borrowing)
• Economic growth (changes in demand)
• Confidence/expectations
• Technological developments (productivity of capital)
• Availability of finance from banks.
• Others (depreciation, wage costs, inflation, government policy)
• Growth of Population
• Element of Uncertainty

Acceleration principle

The acceleration principle is an economic concept that draws a connection between changing consumption patterns and capital investment. It states that if appetite for consumer goods increases, demand for equipment and other investments necessary to make these goods will grow even more. In other words, if a population's income increases and its residents, as a result, begin to consume more, there will be a corresponding but magnified change in investment

What is the role of investment spending in a country's economic development

Investment is the most important economic factor for a nation. Investistment is very important in a country's economic development: It's the main source of employment creation and the main factor of economic growth. Investment increase involves Gross Domestic Product (GDP) and National Revenue increase. Investment induces the economic prosperity and welfare improvement in general.

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