Interest Rates and Aggregate Demand:
The Importance of Investment:
Changes in investment expenditure are the driving force behind the business cycle. With no exception, reductions in investment have played a influential role in every single recession and depression. Raise in investment have spurred every single boom. Therefore if we can understand the causes and consequences of changes in investment spending, we will recognize most of what we need to know about business cycles.Investment as a Share of Real GDP, 1970:
Legend: The considerable year-to-year swings in investment are one of the principal drivers of the business cycle. While investment detonations the economy as a whole booms too.
In the flexible-price model - the real-interest-rate was a market-clearing price. It was pushed up or down by supply as well as demand to equate the flow of savings into financial markets from households as well as businesses, the government and foreigners to the flow of investment funding out of financial markets to finance increases in the capital stock. Supply as well as demand in the loan able funds market determined the interest rate. In the flexible-price model, the stage of savings determined the level of investment and the strength of investment demand determined the interest rate.
In the sticky-price model- the interest rate isn’t set in the loan able funds market. in its place it is set directly by the central bank or indirectly by the combination of the stock of money and the liquidity preferences of households and businesses. The interest rate then figure outs the level of investment which then plays a key role in autonomous spending. Together autonomous spending as well as the multiplier determine the level of output.
What happened to equilibrium in the loan able-funds market? you may ask. In a sticky-price model- the fact that businesses equivalent the quantity they produce to aggregate demand automatically creates balance in the financial market no matter what the interest rate. Any interest rate is able to be an equilibrium interest rate because the inventory-adjustment process has already made savings equal to investment.
Variations in investment have two sources. A few are triggered by changes in the real interest rate r. A lower real interest rate signifies higher investment spending as well as a higher interest rate means lower investment spending. Other variations are triggered by shifts in investors' expectations about profits, future growth and risk. These two basis of fluctuations in investment correspond respectively, to (a) changes in investment expenditure I produced by the interest sensitivity of investment parameter Ir times changes in r and (b) alters in the baseline level of investment I0 in the investment function:
I = Io - Ir x r
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