Question

Essay- Discuss "permanent income" and "life-cycle consumption" theories. Why is investment the most volatile sector of aggregate demand? Explain how interest rates, output, and taxes determine the demand for capital. Discuss the effect of monetary policy on investment spending.

Answer 1

Increased profit opportunities will increase business investment. Aggregate demand will shift to the right and may cause inflation if it goes beyond potential GDP. Higher interest rates reduce investment spending. ...Demand for cheaper imports increases, reducing demand for domestic products.

Consumer Confidence

If consumers are confident about their future income, job stability, and the economy is growing and stable, spending is likely to increase. However, any job insecurity and uncertainty over income is likely to delay spending. An increase in consumer confidence shifts AD to the right.

2. Interest Rates

Lower interest rates tend to increase consumption because consumers purchase larger goods on credit. If interest rates are low, then it’s cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments so that households can spend more on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.

3. Consumer Debt

If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.

4. Wealth

Wealth is assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.

Investment, second of the four components of aggregate demand, is spending by firms on capital, not households. However, investment is also the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of factors of production in the long run.

. Interest Rates

Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.

2. Business Confidence

If firms are confident about the economy and its future growth, they are more likely to invest in capital, new projects and buildings/machinery.

HomeMacroeconomics

MACROECONOMICS

Four Components Of Aggregate Demand

By Prateek Agarwal Last updated Jan 1, 2018

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There are four components of Aggregate Demand(AD); Consumption (C), Investment (I), Government Spending (G) and Net Exports (X-M). Aggregate Demand shows the relationship between Real GNPand the Price Level.



Four Components of Aggregate Demand

Any increase in any of the four components of aggregate demand leads to an increase or shift in the aggregate demand curve as seen in the diagram above.

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

Increase in the Aggregate Demand Curve

1. Consumption

This is made by households, and sometimes consumption accounts for the larger portion of aggregate demand. An increase in consumption shifts the AD curve to the right.

Factors that Affect Consumption

1. Consumer Confidence

If consumers are confident about their future income, job stability, and the economy is growing and stable, spending is likely to increase. However, any job insecurity and uncertainty over income is likely to delay spending. An increase in consumer confidence shifts AD to the right.

2. Interest Rates

Lower interest rates tend to increase consumption because consumers purchase larger goods on credit. If interest rates are low, then it’s cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments so that households can spend more on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.



3. Consumer Debt

If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.

4. Wealth

Wealth is assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.

2. Investment

Investment, second of the four components of aggregate demand, is spending by firms on capital, not households. However, investment is also the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of factors of production in the long run.

Factors that Affect Investment

1. Interest Rates

Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.

2. Business Confidence

If firms are confident about the economy and its future growth, they are more likely to invest in capital, new projects and buildings/machinery.



3. Investment Policy

If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then investment can increase. However, corruption and bureaucracy deters investment.

4. National Income

As firms increase output, they would need to invest in new machines. This relationship is known as The Accelerator. The assumption behind the accelerator is that firms will want to main a fixed capital to output ratio, meaning that if a factory uses one machine to produce 1000 goods, and the firms needs to produce 3000 goods more, then the firm will buy 3 more machines.

Government spending forms a large total of aggregate demand, and an increase in government spending shifts aggregate demand to the right. This spending is categorized into transfer payments and capital spending. Transfer payments include pensions and unemployment benefits and capital spending is on things like roads, schools and hospitals. Governments spend to increase the consumption of health services, education and to re-distribute income. They may also spend to increase aggregate demand.

Imports are foreign goods bought by consumers domestically, and exports are domestic goods bought abroad. Net exports is the difference between exports and imports, and this component can be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate demand to the right. The exchange rate and trade policy affects net exports.

Investment Expenditure
Investment expenditure I represents a smaller share of the total but tends to be the most
volatile component leading to the cyclical behavior of aggregate demand. This category
of expenditure includes fixed nonresidential investment (factories, machines, transport
equipment), fixed residential investment (new houses and apartments), and business
inventories. Often the volatility in investment results from fluctuation in inventory levels
due to changing expectation about business conditions.
Fixed residential and nonresidential investment refers to the creation of income-
producing assets. Assets that will generate net-benefits (benefits - costs from housing
services) in the case of owner-occupied housing or generate profits as part of the
production process. These net-benefits and profits depend on the expected revenue or
gross benefits generated by the asset as well as the costs of acquiring, maintaining and
replacing these assets.
Demand for the production of the asset will directly affect the revenue generated. Strong
demand based on preferences, optimism, purchasing power, or demographics will lead to
the desire for more investment expenditure.
Acquisition costs include both the purchase price of the asset and the borrowing costs
involved both which are highly sensitive to changes in interest rates. Higher interest rates
lead to higher borrowing costs and thus lower net-benefits or profits such that the level of
aggregate investment expenditure may be reduced. Maintenance and replacement costs
depend on the useful life of an asset and its rate of depreciation. Assets that wear out very
quickly or become obsolete in a short period of time have higher costs with the same
effect as rising interest rates. Because of the sensitivity of investment decisions to
changing interest rates, this category of expenditure is easily affected by monetary
policies and activity in the financial sector of an economy.

Government Expenditure
Government expenditure G is a reflection of the fiscal needs and policies of the public
sector in a given economy. This type of expenditure might be in reaction to the demand
for public goods and services by private households and businesses through voting or
other types of political activity. In addition, government expenditure could be used as a
deliberate policy tool to increase nominal incomes in the hope of stimulating aggregate
demand.
Net Export Expenditure
Finally, Net export expenditure NX reflects the international linkages based directly on
service and merchandise flows across borders in addition indirectly reflecting capital
flows into and out of a particular country. Merchandise flows are sensitive to domestic
income levels and preferences for foreign-made goods. In addition these flows are
influenced by exchange rates which determine the domestic price of goods and services
produced abroad. Capital flows depend on interest rate (yield) differentials among nations
as well as exchange rates which affect the domestic price of a foreign asset both at the
time of purchase of that asset and at the time of sale.
Specific spending components may be influenced by the following variables:
Ct = f{income (Yt), wealth (W), taxes (T) , interest rates (r) , and prices (Pt)}
It = f{interest rates (r), capital productivity and longevity, and income (Yt)}
Gt = f{fiscal policies, budgetary needs and borrowing constraints}
NXt = Exports - Imports = f{exchange rates(e.r.), interest rates (domestic& foreign),
income (domestic & foreign)}
In addition, interest rates and exchange rates are affected by activity in the financial
sector of the economy. This activity may include changes in monetary policy as
administered by central banking authorities and changes in expectations of future
economic activity, inflation, and credit risk.
Aggregate Expenditure, Income and the Multiplier
From our discussion of National Income Accounting, one method of calculating nominal
GDP (YN) was through the expenditure approach such that:
NGDP = ΣPiQi = YNominal
or
YNominal = C + I + G + NX
where the variables on the right-hand side represent the four expenditure categories that
make up GDP. What is important is that certain expenditure decisions are proportional to
the level of income such that as aggregate income increases, expenditure increases by
some fraction of this income change. This expression representing an equilibriumcondition (Ye) such that for one unique level of income, expenditure is exactly equal to
that level of income:
Ye : Aggregate Income = Aggregate Expenditure
Note: Holding the price level constant we treat Nominal GDP as being equal to Real
GDP:
(Ye ≡ YN = YR).
We will begin with consumption expenditure 'C' defined as being proportional to
disposable income (gross income less taxes paid) with this proportional relationship
being defined by the marginal propensity to consume 'b':
C = Co + b(Y-T), 0 < b < 1
Tax revenue 'T' is defined to be some fraction of income via the tax rate 't':
T = tY, 0 < t < 1
For algebraic simplicity we will define the other expenditure categories; investment 'I',
government 'G', and net exports 'NX' as being autonomous with respect to income (i.e.,
spending decisions remain independent of the level of national income). We will combine
these values with autonomous consumption ëCoë and summarize this via a single variable
'Ao' known as autonomous expenditure:
Ao = Co + Io + Go + NXo
Thus, the expenditure equation can be written as:
AE = Ao + b(1 - t)Y