Unit 3 Aggregate demand and the multiplier model
3.12 Investment spending in the multiplier model
We can generalize the arguments about both credit constraints and the role of coordination in investment to say that investment spending by firms will respond positively to the growth of aggregate demand in the economy. Once an increase in aggregate spending on the goods and services produced in the economy occurs, this helps to coordinate the plans of firms about their future capacity needs, and stimulates investment spending. Firms’ coordinated expectations of market growth can be measured by a business confidence index.
Figure 3.23 illustrates the relationship between the growth of aggregate demand (excluding investment), business confidence, and investment for the eurozone. The business confidence indicator moves closely with this measure of aggregate demand and investment.
Figure 3.23 Investment, aggregate demand, and business confidence in the eurozone (1996–2022).
Eurostat. 2023. Confidence Indicators by Sector. Federal Reserve Bank of St. Louis. 2023. FRED.
Exercise 3.9 Consulting FRED
For your own country, use data from FRED to construct charts for the growth rate of real GDP, consumption, investment, net exports, and government expenditure.
For example, for the US these series are, respectively: ‘Real Gross Domestic Product’ (GDPC1), ‘Personal Consumption Expenditures’ (PCE), ‘Gross Private Domestic Investment’ (GDPI), ‘Net Exports of Goods and Services’ (NETEXP), ‘Government Consumption Expenditures and Gross Investment’ (GCE). For PCE, GDPI, NETEXP and GCE, you simply need to add ‘Real’ to get the equivalent series in real terms. For all these series, you should find the equivalent ones for your own country.
You can watch this short tutorial to understand how FRED works.
- How has government expenditure evolved in your own country throughout the period for which data is available?
- Comment on the relationship between the growth rate of output and government spending during this period.
- Describe the volatility of government spending and net exports relative to that of GDP and suggest an explanation for the patterns you observe.
Back to the aggregate investment function: Profit expectations vs interest rates
We have now explored a range of explanations for why we would expect investment spending to be volatile, and in particular, highly responsive to expectations of future profits.
When we set out the extended multiplier model in Section 3.8, we also assumed that a rise in interest rates would reduce investment spending. We shall examine the mechanisms underlying this response in more detail in Unit 5.
- investment function (aggregate)
- A relationship that shows how investment spending in the economy as a whole depends on other variables, such as the interest rate and profit expectations. See also: interest rate, rate of interest, profit.
At this stage, we summarize the roles of both profit expectations and interest rates in the aggregate investment function, which we introduced in Section 3.8 and restate here:
\[I = a_0 − a_1r\]The autonomous investment term, \(a_0\) , is the intercept with the horizontal axis: the amount of investment that would take place if the interest rate fell to zero. This captures all the determinants of investment other than interest rates, and in particular expected profitability. In Unit 5, we shall learn why there is nothing to prevent interest rates being zero, or negative.
The coefficient, \(a_1\), captures the sensitivity of investment to the interest rate, \(r\).
In Figure 3.24, the response of investment to a change in the interest rate is illustrated by the movement from C to E. Empirical evidence suggests that investment is relatively insensitive to the interest rate, so the investment function is drawn with a steep slope.
Figure 3.24 also shows the effect of a change in the expected profitability of investment, which raises investment from C to D if the interest rate remains unchanged at 4%.
The limited effect of changes in the interest rate on business investment (illustrated by the steepness of the lines in the figure) highlights the importance of the factors that shift expected profits, and hence the investment function.
Figure 3.24 Aggregate investment function: effects of the interest rate and profit expectations.
Potential investment projects
Investment increases
An increase in profit expectations
Investment in the multiplier model
In the multiplier model, investment spending is a component of aggregate demand, AD. When we plot the AD curve, as in Figure 3.16, the horizontal axis measures output, \(Y\), so, for any given AD curve, all other determinants of AD, including the impact of the interest rate on investment, are being held constant. Therefore in this diagram, the aggregate investment function, \(I = a_0 − a_1r\), appears in the intercept term. As illustrated in Figure 3.16, changes in \(r\) shift the AD function. Since a fall in \(r\) increases investment, it causes the AD curve to shift up. The same applies to any of the determinants of autonomous investment, \(a_0\). So a rise in expected post-tax profits will also shift the AD curve up. This could occur because of the coordination of optimistic beliefs about the growth of markets as discussed in Section 3.11, for example, or because of the introduction of a new technology that reduces the cost of production.
Question 3.15 Choose the correct answer(s)
Figure 3.24 depicts the aggregate investment function of an economy.
Based on this information, read the following statements and select the correct option(s).
- The investment line represents the relationship between investment and interest rate, ceteris paribus. Therefore the fall in investment would be shown by a movement up the original line (from E to C, for example), not a shift of the line.
- A rise in corporate tax would decrease expected profits, shifting the investment line inwards. This results in a fall in investment.
- Higher demand makes it profitable to invest in larger projects, increasing investment at a given interest rate.
- A steeper line means smaller changes in investment when the interest rate moves, that is, lower sensitivity of investment to the interest rate.
