Question

3. Providing a suitable example, explain how Investment Spending (I) depends on interest  rates.

4. Based on the following equation and assumptions, answer the questions: 

For an economy, Y = C + I (here Y stands for national income, C stands for consumer spending, I stands for investment  spending) 

C = 400 + .6Y 

I = Planned Investment + Unplanned investment 

Planned investment is fixed at 500 

Planned expenditure = C + Planned Investment 

No government and closed economy

a. If Y=2500, what will be C and planned expenditure? (10) b. What is the amount of unplanned investment if Y=2500? (10) c. If Y=800, find planned expenditure. (10) 

d. Find the Y for which Y = Planned expenditure.

Answer 1

(3)

Typically, higher interest rates reduce investment because higher interest rates increase the cost of borrowing and require investment to have a higher rate of return to be profitable.

As shown on the graph above, if interest rates rise from 5% to 7%, then we get a fall in the quantity of investment from 100 to 80.

If interest rates are increased, then it will tend to discourage investment because investment has a higher opportunity cost.

(4)

$Y=C+I$

$C=400+0.6Y$

Planned Investment=500

Planned Expenditure$=(400+0.6Y)+500$

(a)

If $Y=2500$

$C=400+0.6Y$

$C=400+0.6(2500)=1900$

Planned Expenditure$=C +500$

$=1900+500=2400$

(b)

$Y=2500$

$C=1900$

$Y=C+I$

$2500=1900+I$

$I=600$

Unplanned Expenditure=I- Planned Investment.

$=600-500=100$

(c)

If $Y=800,$

Planned Expenditure:

$=(400+0.6Y)+500$

$=(400+0.6\times 800)+500$

$=1380.$

(d)

Y for which Y= Planned Expenditure.

$Y=(400+0.6Y)+500$

$400+500=Y-0.6Y$

$900=0.4Y$

$Y=2250$