Question

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QUESTION: How will a decrease in output during a recession affect (explain)

a)business fixed investment?

ANSWER GIVEN: Lower output reduces employment and the marginal product of capital, which, according to the neoclassical model of investment, will reduce business fixed investment.

QUESTION ABOUT THE ANSWER GIVEN: Why does lower output reduce the MPK? Why does a reduction in the MPK reduce business fixed investment?

b) residential investment

ANSWER GIVEN: The reduction in employment and income during a recession reduces the demand for housing, the relative price of houses, and residential investment spending.

QUESTION ABOUT ANSWER GIVEN: why does the reduction in employment and income reduce the relative price of houses and residential investment spending?

c) inventory investment?

ANSWER GIVEN: According to the accelerator model, lower output reduces the stock of inventories that businesses wish to hold and will reduce inventory investment.

QUESTION ABOUT ANSWER: Why does a decrease in output during a recession reduce the stock of inventories business wish to hold? Why does this reduce inventory investment?

Answer 1

Introduction

Before, answering all the sub parts as per the details shared, it is important to know the meaning of a recession. A recession refers to an economic phase or cycle wherein the aggregate or total demand for goods and services declines for any reason. For example, during the Corona Virus Pandemic, the aggregate demand decline because people were not allowed to go outside their houses.

As the demand declines, producers do not make profits which they earlier used to and this therefore reduces the overall output as producers find it difficult for them to be able to sell goods or services in the market place. As they do not make sufficient profits, they do not have enough capital to support the labour force and to reduce costs, firing takes place in the organization.

Thus, a cycle emerges, wherein low demand leads to low output and therefore low income for both producers as well as those who work for producers i.e. labour force which translates into consumers.

Accordingly, the effect of recession on all of the inquired questions and doubts as raised are as follows: -

Case Details: -

A) Business Fixed Investment: -

As explained in the section above, during a recession the aggregate demand for goods and services is low, which reduces the overall output. Now that we understand that point, we need to know the meaning of Marginal Product of Capital which refers to the additional production that a firm will have as it increases its capital.

During a recession, since the firm does not have enough capacity to keep the current people hired and the overall strength of the working population in the organization decline, addition of capital to increase production level is plain sight non profitable business tactics.

As our labour force is declining due to the lack of funds, allocating the same towards increasing production is not possible. Even if the firm wanted to add, it would not get equal returns that it used to earlier. Therefore, the Marginal Product of capital therefore declines rapidly.

Now, moving over to business fixed investment, as firms become reluctant to invest money due to declining productivity as they cannot hire staff in equal numbers due to rising costs and reduced profits, the overall business fixed investment declines. Firms do not anticipate future profit and realize that even if they invest in fixed assets their overall productivity will remain low as additional output is not required at present due to low market demand and the reduced investment in labour force would make such investment useless as the productivity and profits would not increase till the time, there is sufficient demand in the market place. Thus, the incentive of the producer to increase his investment in fixed assets is not there in a recession therefore, decreasing business investment.

B) Residential Investment: -

As people lose their jobs due to recession, their capacity to purchase goods and services decline. They need to withdraw money from their savings and do not have additional sources of revenue, which they may use to make a purchase.

Consider the simple fact that a person was earning 5000$ per year and this declines to 0 due to rising unemployment in the economy which resulted from a recession and slow aggregate demand. The last thing on a consumer’s mind at this point of time would be to purchase houses. All he would want is to save his money and reduce consumption levels as far as technically possible for him.

As demand for housing decreases, those that are selling the same would have no choice, but to sell it for a lesser price in the markets thus, resulting in an overall decline in market prices of houses.

We can conclude by saying, that people do not have money during a recession due to unemployment and this reduces the demand for the same. When demand is lower, producers are left with no choice but to offer the same for a lesser consideration thus reducing prices in the market for real estate.

C) Inventory Investment: -

As a producer, we have anticipated the fact that we are in a recession, meaning that the aggregate demand for goods and services remains low. For example, during the COVID recession which has hit the world economy, people are reluctant of going out of their houses and markets remain shut.

During this time period it has become impossible for producers to function with previous levels of investment into inventory, owing to the fact that the overall demand for goods and services has remained low. There is no need to invest more into inventory during this time because it will only add to costs of operations as the final products would go unsold in the markets.

Please feel free to ask your doubts in the comments section if any.