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.

This line chart shows data for investment, aggregate demand, and business confidence in the Eurozone from 1996 to 2022. The horizontal axis shows the year, ranging from 1996 to 2022. There are two vertical axes. The vertical axis on the left shows the growth rate in % of 2 measures: Growth of demand (C + G + X – M) and Growth of investment (I), and ranges from -15% to 10%. The vertical axis on the right shows industrial confidence indicator as an annual average, ranging from -30 to 20. Growth of demand starts at around 2% in 1996 and stays within 0% to 5% until 2009 when it falls to around -2%, recovering to around 2% in 2010 before falling again to 0% in 2012. Demand increases again to around 2% in 2017 before falling steeply to below -5% in 2020, recovering to around 5% in 2022. Growth of investment is more volatile but follows a similar pattern to demand, where in 2008 from 5% it declines steeply to below -10% in 2009, recovering again to around 5% in 2015, falling in 2020 to below -5%, and finally recovering to around 5% in 2022. Industrial confidence follows the pattern of both investment and demand, where in 2009 when both the other indicators see a decline, the industrial confidence index falls from around 5 in 2008 to almost -30 in 2009. It rises again as investment and demand rise, and falls from around 5 in 2018 to below -10 in 2020, recovering to around 5 in 2022.
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https://www.core-econ.org/macroeconomics/03-aggregate-demand-12-investment-spending.html#figure-3-23

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.

  1. How has government expenditure evolved in your own country throughout the period for which data is available?
  2. Comment on the relationship between the growth rate of output and government spending during this period.
  3. 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.

In this figure, the horizontal axis shows Investment, I, and the vertical axis shows two measures: Interest rate and profit rate in %. The coordinates are (Investment, Interest rate/Profit rate). There is a downward-sloping straight line labelled “I_{initial} = a_0 – a_1r”, which is investment (I) holding profit expectations constant. There is a second dotted downward-sloping straight line to the right of I_{initial} and parallel to it at a higher level of investment labelled “I_{new} = a^prime_0 – a_1r” which is investment (I) with higher profit expectations. Point C lies on I_{initial} when the interest rate is 4%. Point D lies on I_{new} at a higher level of investment when the interest rate is 4%. Point E lies on I_{initial} at a lower rate of interest of 3%. The horizontal distance between C and D is the change in Investment labelled delta I.
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https://www.core-econ.org/macroeconomics/03-aggregate-demand-12-investment-spending.html#figure-3-24

Figure 3.24 Aggregate investment function: effects of the interest rate and profit expectations.

Potential investment projects: In this figure, the horizontal axis shows Investment, I, and the vertical axis shows two measures: Interest rate and profit rate in %. The coordinates are (Investment, Interest rate/Profit rate). There is a downward-sloping straight line labelled “I_{initial} = a_0 – a_1r”, which is investment (I) holding profit expectations constant.
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https://www.core-econ.org/macroeconomics/03-aggregate-demand-12-investment-spending.html#figure-3-24a

Potential investment projects

In an economy with many thousands of firms, all their potential investment projects are represented by a downward-sloping aggregate investment function with equation, \(a_0 − a_1r\).

Investment increases: In this figure, the horizontal axis shows Investment, I, and the vertical axis shows two measures: Interest rate and profit rate in %. The coordinates are (Investment, Interest rate/Profit rate). There is a downward-sloping straight line labelled “I_{initial} = a_0 – a_1r”, which is investment (I) holding profit expectations constant. Point C lies on I_{initial} when the interest rate is 4%. Point E lies on I_{initial} at a lower rate of interest of 3%, and a higher level of investment. The horizontal distance between points C and E on the horizontal axis is the increase in investment labelled delta I.
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https://www.core-econ.org/macroeconomics/03-aggregate-demand-12-investment-spending.html#figure-3-24b

Investment increases

In response to a fall in the interest rate, the economy moves along the investment function from C to E. Investment increases by \(\Delta I\).

An increase in profit expectations: In this figure, the horizontal axis shows Investment, I, and the vertical axis shows two measures: Interest rate and profit rate in %. The coordinates are (Investment, Interest rate/Profit rate). There is a downward-sloping straight line labelled “I_{initial} = a_0 – a_1r”, which is investment (I) holding profit expectations constant. There is a second dotted downward-sloping straight line to the right of I_{initial} and parallel to it at a higher level of investment labelled “I_{new} = a^prime_0 – a_1r” which is investment (I) with higher profit expectations. Point C lies on I_{initial} when the interest rate is 4%. Point D lies on I_{new} at a higher level of investment when the interest rate is 4%. Point E lies on I_{initial} at a lower rate of interest of 3%. The horizontal distance between C and D is the change in Investment labelled delta I.
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https://www.core-econ.org/macroeconomics/03-aggregate-demand-12-investment-spending.html#figure-3-24c

An increase in profit expectations

This shifts the investment function to the right, \(I_\text{new}\): if the interest rate is held constant at 4%, investment increases from C to D, that is, by \(\Delta I\).

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).

  • Ceteris paribus, an increase in the interest rate would lead to a fall in investment due to an inward shift of the investment line.
  • A rise in corporate tax would shift the investment line outwards.
  • A forecast of a permanent demand increase shifts the investment line outwards.
  • A steeper line indicates the lower sensitivity of the level of aggregate investment to changes in interest rate.
  • 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.