Investment Spending Is Very Significant Because it

Investment spending is very significant because it is an essential ingredient in economic development and growth. The decrease in the level of investment spending may cause a recession. Most recessions occur as a result of fall in investment spending (Paul & Krugman, 2007). Swings in investment spending are very dramatic than those in customer spending. Reduction in consumer spending is normally a result of a progress that starts with a slump in investment spending. The most significant factors that determines investment spending are the rate of interest and anticipated future real GPD. To understand the kind of reasoning, first there is a need to note that planned investment spending is the investment spending that firms intend to pass through over a given period, in contrast to investment spending that happen but is not planned (William & Greene, 2008). Planned spending on investment projects is negatively the same as the interest rate. A higher interest rate leads to a small level of planned investment spending.

The aggregate demand and aggregate supply curves are the basic macroeconomic tools for studying output fluctuations and the determination of price level and the inflation rate. These tools are basically used to understand why the economy deviates from a path of a smooth growth over time and to explore the consequences of government policies intended these output fluctuations (Paul & Krugman, 2007).

The aggregate supply curve describes, for each given price level, the quantity of output firms are willing to supply. It is upward sloping because firms are willing to supply more output at higher prices. The aggregate demand curve on the other hand shows the combinations of the price level and the level of output at which the goods and money markets are simultaneously in equilibrium. (Froyen 2009) The aggregate demand curve is downward sloping because higher prices reduce the value of the money supply which reduces the demand for output.

Figure 1 (Combined aggregate demand AD and aggregate supply AS) shows that an increase in the money supply shifts the aggregate demand to the right

Figure 1

Therefore an increase in the money stocks causes both the level of output and the price level to rise. It is clear from figure 2 below that the amount by which the price level rises depends on the slope of the aggregate supply curve as well as the extent to which the aggregate demand curve shifts and its slopes.

Figure 2

Aggregate supply curve

The aggregate supply curve, as discussed earlier, describes, for each given price level, the quantity of the output firms are willing to supply. There are two types of the aggregate supply curve: Horizontal curve (Keynesian aggregate supply curve) and the vertical one (The classical aggregate supply curve) (Hall & Tylor 1989)

The classical supply curve

This curve is vertical, indicating that the same amount of goods will be supplied whatever the price level. Diagrammatically it can be represented as follows in figure 3. This curve is based on the assumption that the labor market is in equilibrium with full employment of the labor force. If the idea that the aggregate supply curve is vertical in the long run makes you uncomfortable since price level means overall prices.

Figure 3

Keynesian aggregate supply curve

It is named after J.M Keynes. It is horizontal; indicating that firms will supply whatever amount of goods is demanded at existing price level. The idea underlying Keynesian aggregate supply is that because there is unemployment, firms can obtain as much labor as they want at the current wage. Their average costs of production therefore are assumed not to change as their output levels changes.

Figure 4

The price adjustment mechanism

The aggregate supply curve describes the price adjustment mechanism of the economy. It can be given in a summarized equation as follows:

Pt+1 = Pt [1 + ?(Y -- Y*)]

Where Pt+1 are the price level next period, Pt is the price level today and Y* is potential output. The speed of price adjustment is controlled by the parameter ?. If ? is large, the aggregate supply curve moves quickly. If ? is large, the aggregate supply mechanism will return the economy to potential output relatively quickly; if ? is small, aggregate demand policy may be used to speed up the process (Paul & Krugman, 2007). This equation embodies the idea that if output is above potential output, prices will rise and be higher next period. If prices are below potential output, prices will fall and be lower next period.

In summary a relatively flat aggregate supply curve means that changes in output and employment have a small impact on prices. The position of the short-run aggregate supply schedule depends on the level of prices.

Aggregate demand curve

This curve shows the combinations of the price level of output at which the goods and money markets are simultaneously in equilibrium. Expansionary policies such as government spending, cuts in taxes and increase in money supply move the aggregate demand curve to the right.

Consumer expenditure is the largest component of the aggregate demand. The aggregate demand curve and the price adjustment line govern the movement to potential GNP. After being pushed away from potential GNP by monetary or fiscal policies- whether towards slack or overfull employment- the economy will eventually reach potential GNP. Expected inflation responds to past inflation that is why the economy overshoots potential GNP. An increase in money supply increases GNP in the short run but eventually this effect wears off as the price level rises. In the long run an increase in the money supply has no effect on GNP (Froyen, 2009)