Aggregate Expenditure Model

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Aggregate Expenditure Model

• Investment

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Investment

• Is the second component of private spending
  (beside C).
• Investment consists of expenditure on new plants,
  capital equipment, machinery, inventories
• Investment decision marginal benefit vs.
  marginal cost

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• If expected rate of return gt interest rate of
  borrowing funds invest
• If expected rate of return lt interest rate of
  borrowing funds not to invest
• Note that investors take their investment
  decision based on the real interest rate
• Rnominal rate rate of inflation

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Deriving the investment demand curve

• What determine the amount of funds that investors
  borrow?
• Real interest rate (rr) an increase in rr will
  increase the cost of borrowing funds, thereby
  reducing the amount of I.
• A decline in rr will reduce the cost of borrowing
  funds, thereby increasing I.

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Investment Demand Curve (ID)

• rr
• 
  ID

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Determinants of I

• Changes in the level of rr will lead to a move in
  ID curve.
• This is the only factor leading to a move along
  the ID curve.
• All other factors will shift the ID curve.

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Other determinants of I

• 1. Acquisition, maintenance, and operating costs
  The initial and then the operating cost of
  capital affect the expected rate of return in I.
• 2. Business Taxes increase in taxes will reduce
  expected profitability.

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• 3. Technological changes stimulates investment
  and lower production costs.
• 4. Stock of capital goods as inventories rise,
  expected rate of return on investment increase.

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• 5. Expectations EX(r) depends on firms
  expectations about sales, future operation costs,
  future profitability

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Investment and Real Outputs

• We now related the level of (I) to the level of
  real outputs and income.
• We will assume that we have planned I that is
  independent of the level of DI and real outputs.
• This is the case since I level is instable.

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Equilibrium GDP

• Now we combine both C and I to explain the
  equilibrium level of outputs, income, and
  employment.
• The following table shows this process

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