Question

Explain each in-depth and why.

How do consumption and investment spending affect aggregate expenditures and output over the business cycle?

Which is more responsible for volatility - consumption or investment spending or both?

How do government actions affect consumption and investment?

Answer 1

Aggregate expenditure is affected by total expenditures in 4 sectors, namely household, business, government, and foreign. The sum of expenditures from these 4 sectors form the four components: consumption, investment, government expenditure and net exports.

AE = C + I + G + (X-M)

where C is consumption expenditures by the household sector; I is investment expenditures on capital goods by the business sector, G is government purchases; and (X - M) is net exports, with X being exports and M being imports.

C captures the expenditures by the household sector on final goods and services undertaken in a given time period, while the business sector is responsible for investment expenditures I, for capital goods like factories and equipment. Both C and I have a positive relationship with AE and output. An increase in C and/or I would lead to a simultaneous increase in AE. The changes in both consumption and investment will directly affect the aggregate expenditure or output on the business cycle. Consumption expenditure affects AE through MPC (marginal propenity to consume).

Out of the two, investment spending is responsible for volatility and affects business cycles stability. Investment spending is dominated by larger entities, and is more sensitive to economic indicators like interest rates and other large-scale economic factors than consumption expenditure. Mostly, consumption expenditure is a necessity while investing is completely optional and only takes place when macro conditions are good.

Government actions can affect consumption and investment through various policy tools. To some extent, the government's taxation policy decides the disposable incomes of the people and hence their consumption expenditures. Similarly, Government is also responsible for indicators like interest rates etc, which influence investment spending. High interest rates would discourage I, while lower rates would encourage firms to expand.