Question

Question 3 [20 Marks]

The author, in her/his conclusion, highlighted the challenges facing the economy in a statement: “What we are not hearing is significant expansion plans. The government balance sheet prevents it from stimulating the economy – it has to come from the private sector.” As an economist, you have been tasked to explain to a business forum how investment can be used to expand the economy. In your presentation, critically review four factors directly linked to investment and how this causes a shift in aggregate demand (AD) curve. [20 Marks] (1 mark for each identified factor 4 marks for explaining each factor).

Answer 1

Aggregate demand (AD) refers to the total demand (consumption desire) for goods and services in an economy, as a whole. It may be explained in the form of an equation as follows:

Y = C(Y-T) + I(r) + G + NX(e)

where, Y = Aggregate Demand

C(Y-T) = Consumption as a function of disposable income i.e. income less of taxes

I(r) = Investment as a function of Interest rate

G = Government Spending

NX(e) = Net exports i.e. Exports minus Imports

There are 4 key factors directly linked to investment that cause a shift in the AD curve. These are:

1. Consumption Spending: There may be a change in Consumer's spending on goods and services due to any kind of shortfall caused to the disposable income available for spending on that good or service, either due to rise on cost of living or taxes or both. As a result, consumer's overall demand may go down and lead to a leftward shift in AD curve, and vice versa.
   
2. Investment Spending: In a situation when there is a rise in demand for loan by businesses, especially when there is a rise in savings capital in the economy. This may lead to an increase in investment spending by businesses.
   
3. Government Spending: Goverment monitors its spending through fiscal and monetary policy. These policies can either be - Expansionary or Contractionary. Expansionary policy leads to a higher level of money supply to overcome inflationary price rise by increasing economic activity. Monetary policy is a tool used by govermnment to monitor money supply in the economy. Expansionary Monetary policy is adopted when the interest rates are decreased, which makes loans more attractive and less expensive while savings less attractive. This leads to more money in circulation and hence higher economic activity, leading to a rightward shift in AD curve. While an contractionary monetary policy does the reverse. An expansionary fiscal policy refers to a situation when government increases its spending and reduces taxes. This leads to more money supply in the hands of the consumer and hence increase in aggregate demand.
   
4. Net Exports: As the real exchange rate rises, it leads to domestic currency becoming stronger, which further causes imports to rise and exports to fall, therefore net exports to fall. This would further lead to aggregate demand curve to shift left, since foreign market would be more cheap as compared to domestic due to strengthening of the domestic currency. The reverse happens if the exchange rate falls.