Factors affecting investment spending Real interest rate Technological progress Expected future output or income Current corporate income tax rate and Expected (future) corporate income tax rate Current output (Income)

Investment Curve Investment Curve shows the negative relationship between r (real interest rate) and the volume of investment spending (I). We will show this graphically. I Curve is negatively sloped because: a) As real interest rate increases the cost of borrowing rises which reduces the demand of capital investment. OR ALTERNATIVELY we can say that b) As more and more capital is used (with the same amount of labor and constant technology) marginal productivity of capital decreases due to the law of diminishing marginal productivity. And this decreases the (marginal) rate of return on capital.

Given a certain real interest rate (MARGINAL COST OF BORROWING) I curve specifies the OPTIMAL (PROFIT MAXIMIZING) VOLUME of INVESTMENT spending (or demand for capital). We will show this graphically And change in the level of technology, current and expected future output, current and expected future corporate income tax rate will shift I curve by changing the (expected) marginal rate of return on capital at each level of investment.

1. Real interest rate Real interest rates affect cost of borrowing; higher real interest rate leads to a lower volume of investment spending because an increase in real interest rate increases the cost of borrowing leading to an increase in the (expected) marginal cost of investment at each level of investment.

2. Technological progress Technological progress increases the productivity of capital goods leading to higher expected marginal rate of return on capital for each level of capital investment. And this leads to increased investment spending.

3. Expected future output or income Expectations of an increase in future output (income) of the economy means expectations of higher sales and therefore expectations of higher profits in the future. This affects current investment positively.

4. Expected future corporate income tax rate Expectations of an increase in future corporate income tax rate (or an increase in the current corporate income tax rate) lowers expected profitability of capital investment leading to a decrease in current investment.

5. Current output (Income) An increase in current output (Y) of the economy means higher volume of sales and higher profits. And this can make firms want to add to their capacity by increasing their investment. Note: However for simplicity we will assume that I is not a function of current output (Y). In other words; I is autonomous of Y! Therefore I = I I can change as result of a change in any of the factors listed above.

Government Spending Again for simplicity we will assume that G is autonomous of Y: G = G Note: However in the real world G may be a positive or negative function of Y. For example, if Y is increasing rapidly this may add to inflationary pressures making some governments attempt to lower g in order to reduce or control aggregate demand in order to prevent inflation to rise. On the other hand, as Y increases Tax Revenues will increase allowing government to increase G.

Net exports (Trade Balance): X X = E – M = g – mY E = Exports of goods and services M = Imports of goods and services Assumption: Exports is autonomous of Y and depends on the other factors such as; Incomes of trade partners of that country Tastes and preferences of foreign consumers Relative price of exports against foreign products M = mY  0 < m < 1 m = marginal propensity to import Imports are positively affected by output (or Income)

Aggregate Demand (or Total Spending) AD = C + I + G + X C = a + b (1-t) Y I = I G = G X = g – mY Substituting 2, 3, 4, and 5 into 1We obtain: AD = a + I + G + g + [b(1-t)-m]Y a + I + G + g = autonomous component of AD for domestic output [b(1-t)-m]Y = induced part of AD. This is the part that depends on Y! Autonomous component depends on factors other than income!

Now we will show the AD function graphically and explain the relationship between AD and Y through the slope of the function given by [b(1-t)-m]. And then we will show how AD shifts as any one of the autonomous components of AD changes and how it rotates if any parameter that affects slope changes. Later on we will use AD (or total spending) function to understand how the equilibrium level of Y and AD (Spending) is determined and how this equilibrium is affected if there is a change in Fiscal policy of government Investment spending of firms Autonomous part of consumption Exports

Fiscal Policy Fiscal policy has two instruments: t and G So government can apply fiscal policy either by changing t or by changing G or by changing both G and t We will analyze this topic in detail later on!