Question

Topic 8 Spending and Output in the Short Run

8.1 Explain the errors of the following arguments made by an economicsstudent:

a) “The textbook said that a higher interest rate lowers investment, but that doesn’t make sense. I know that if I can get a higher interest rate, I am certainly going to invest more in my savings account.”

b) “The newspaper said that the recent recession was caused by a decline in investment. This can’t be true. If there had just been a decline in investment, the only firms hurt would have been construction firms and other firms selling investment goods. In fact, many firms experienced falling sales during that recession, including department stores and firms selling consumer electronic products.”

8.2 Company A in country X is considering the investment in a project with the following (estimated) cost and benefit. The project has a life of 3 years and has zero value after the third year.

Period(year)	0	1	2	3
Cost of investment ($ million)	11.7	-	-	-
Profits ($ million)	-	2.5	4.5	6

a) Suppose in year 0 Company A could borrow or lend at an annual interest rate of 4%. Explain clearly with calculation whether Company A will invest in this project.

b) Based on your answer in part (a) explain how an increase in interest rate to 5% will affect Company A’s investment decision.

c) There is a concern about the unemployment problem in country X and the lack of investment demand is regarded as one of the major reasons of unemployment. Suppose other firms in country X will be affected in the same way as Company A as described in part (a) and (b) above. Use the Keynesian model to explain the process of how a change in interest rate may help to solve the unemployment problem.

8.3 Consider the following Keynesian model: Consumption:

C = 200 + 0.7Yd

Lump-sum tax: T0 = 50

Proportional Tax Rate: t = 0.2

Government Expenditure: G = 435

Planned Investment: I = 300

Exports: X = 100

Imports: M = 0.06Y

Yd: Disposable Income

Numbers are in billion dollars.

Output (Y)	Disposable income (Yd)	Consumption (C)	Planned Investment (Ip)	Government expenditure (G)	Export (X)	Import (M)	PAE
1500
1750
2000
2250
2500

a) Each row corresponds to one possible output level. Fill in the remaining columns of the table given the equations given above.

b) What is the equilibrium output level of this economy?

c) What is the level of unplanned investment at the output level of 1500 and at the level of 15 2500? If it is not in equilibrium, describe how the economy would adjust to the equilibrium in each case.

d) What is the change of equilibrium output when government expenditure increases to 560? Explain your steps. What kind of policy is it?

e) If investment decreased to 175 billion dollars under policy uncertainty, how does it change the equilibrium output level? Is the change in equilibrium output larger than the change in investment? Why?

f) What factors would affect the size of expenditure multiplier? Briefly explain

Answer 1

Answer 8.1

a) In this statement, the interest rate being talked about is not the savings rate of interest but the lending rate of interest. Also, saving in a savings bank account is not investment. Saving simply means putting aside money for future use. Putting that money in a savings account might give some returns but those returns would be low and would generally involve very low risks. Whereas Investment refers to the purchase of any asset with the goal of generating further income or something which can further be used in the production process to produce more goods or services. Investment is done with the objective of earning higher returns and it generally involves higher risk as compared to savings.

When the interest rate goes up, the cost of borrowing goes up and hence the investor would not borrow more and therefore the investment will go down. There exists an inverse relationship between interest rate and rate of investment as interest rate is the cost of borrowing for investment purposes.

Whereas if we talk about savings and the interest on savings then there exist a positive relationship between savings and interest on savings. As the interest goes up, people save more. But it does not necessarily mean that whatever is saved will actually be invested.

Saving more in a savings account is not the same as investing more.

b) Investment does not only relate to investment in construction firms and firms selling investment goods. Instead, Investment refers to the purchase of any asset or good with the objective of generating future income or cash flow or for purchasing goods or machines which can be used in the production process to produce more goods or services. In terms of finance, investment can also mean purchasing an asset to resell it in the future at a higher price in order to make capital gains.

So all firms, whether it is a department store or a firm selling electronic items or selling clothes, involve investment. The money invested in the purchase of the shop or the amount being paid as rent, as electricity bill, the amount spent on purchase of inventory, purchase of furniture, or other basic requirements for the firm, all of these constitute a part of investment.

So investment needs to be done in all kinds of firms whether big or small, or relating to construction or selling, or financial assets or jewellery. When investment falls, in can fall in any sector and can cause recession which will lead to declining sales across sectors. It does not necessarily have to be in construction sector or investment goods sector.