Answer to Question #139671 in Macroeconomics for Ah zhuan

Question

2) Graphically illustrate the effects of business investment on aggregate demand. Would you expect it to have a multiplier effect? Why or why not? 3 marks

Answer 1

Investment is a component of aggregate demand: $AD = C + I + G + NX.$ A business investment will, thus, stimulate a change in demand by an amount equal to a change in investment times the size of the multiplier. This implies that if business investment increases, then, the aggregate demand will also increase by a multiple of the initial increase in investment and vice-versa. The diagrams below demonstrate how a change in investment would impact aggregate demand, assuming a multiplier of 5.

As shown on the diagrams, a change in investment by $100 bn, probably due to a change in interest rate, 3% as shown on the diagram, would cause a change in aggregate demand and a change in real GDP by $500 bn ($100 bn * 5).

Thus, an increase in investment by $100bn - a movement from point A to B on the investment function - would cause an increase in aggregate demand from AD1 to AD2 followed by an increase in real GDP by $500 bn due to the multiplier effect, assuming a multiplier of 5. The opposite is true for a fall in investment, and the multiplier will operate in reverse order - the negative multiplier. As indicated on the second diagram by a movement from C to D, the level of real GDP changes at every price level.

The initial change in investment will have a multiplier effect on aggregate demand because the initial change in investment will affect output, leading to a change in income, which in turn leads to a further change in aggregate demand. The only exception is when the marginal propensity to consume is zero (MPC = 0) in which case the marginal propensity to save is unit (MPS = 1) and the multiplier is also unit (k = 1). When k = 1, a change in investment will impact aggregate demand by the same amount.