Investment (I): The addition of capital stock to the economy, investment is carried out by firms; it includes all goods that are made by people and are used to produce other goods or services such as factories, machines, offices, or computers → there are two types of investment:
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Replacement Investment: When a firm spend on capital in order to maintain the productivity of their existing capital
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Induced Investment: When firms spend on capital to increase the output to respond to higher demand in the economy
What causes change in investment:
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Interest Rates: The money that firms use for investments comes from several sources; they can use their existing profits or they can borrow the money → lowered interest rates leads to higher amount of investment as firms can borrow more money
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Changes in National income: As national income rises, so does consumption; if income and consumption are rising, there will be pressure on the existing capacity of firms, causing them to invest in new capital to meet the increase in demand (induced investment) → investment accelerates when national income rises
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Technological change: In order to keep up with advances in technology and remain competitive, firms will need to invest in technology
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Expectations/Business confidence: There would be little point in investing to increase the potential output of a firm if consumer demand is likely to fall in the future → measured in “business confidence index”
Government Spending (G): Governments spend money on a wide variety of goods and services at a variety of levels (federal, state, municipal) → these include health care, education, law and order, transport, social security, housing, and defense; the amount of government spending depends on its policies and objectives
What causes changes in government spending:
If a government has made a commitment to financially support a given industry, then government spending will rise. If governments are obliged to correct market failures, then it will also rise. A new educational of health policy might require increased public spending on schools or hospitals.
Net Exports (X – M):
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Exports (X): Domestic goods and services that are bought by foreigners; when firms sell exports to foreigners, it results in an inflow of export revenues to the country
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Imports (M): Foreign goods and services → result in an outflow of import expenditure
AD = C + I + G + (X – M)
What causes changes in net exports:
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Exports: If foreign incomes rise, then their consumption of imported goods and services will rise
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Imports: As people consume more goods and services, there will be an increase in the amount of imported goods and services. Similarly, if national income rises, there is likely to be greater investment → part of the capital goods that are purchased will be imported capital goods or components → overall, as national income rises, so does spending on imports
Fiscal Policy: The set of a government’s policies relating to its spending and taxation rates. Direct taxes (taxes on income) or indirect taxes (taxes on goods and services) can be raised or lowered to alter the amount of disposable income that consumers have. Governments use expansionary fiscal policy to increase aggregate demand and contractionary fiscal policy to reduce aggregate demand.
- If a government would like to encourage greater consumption, then it can lower income taxes to increase income, increasing AD
- If a government would like to encourage greater investment, then it can lower corporate taxes so that firms enjoy higher after-tax profits that can be used for investment
Monetary Policy: The set of official policies governing the supply of money in the economy and the level of interest rates in an economy. Changes in the central bank’s base rate can affect the level of AD in the economy. By reducing rates, it reduces the cost of borrowing and can lead to increases in both consumption and investment. This is known as “loose” monetary policy.