Weakening business sentiment will not lead to interest inelastic investment.

Introduction

Investment expenditure is the expenditure made by firms on goods produced not for their present use but for their use in the future. In economics, investment is comprised of business fixed investment (i.e. new factories and machinery), residential investment (i.e. new houses, apartments and condominiums) and inventory investment (i.e. the change in the value of unsold goods).

Many students think that weakening business sentiment will lead to interest inelastic investment. Mr. Edmund Quek will discuss this economic misconception in economics tuition with the students.

Exposition

A fall in interest rates will lead to an increase in investment expenditure, and vice versa. In a large economy, interest rates generally fall due to central bank intervention in the money market. To increase economic growth or decrease unemployment, the central bank can increase the money supply by conducting an open market purchase. When the money supply increases, the amount of reserves in the banking system will rise. When this happens, interbank rates will fall which will lead to a fall in the level of interest rates in the economy. Lower interest rates will decrease the incentive to save and the costs of borrowing and this will lead to an increase in consumption expenditure. Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure and investment expenditure will lead to an increase in aggregate demand resulting in an increase in national output. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment. A limitation of expansionary monetary policy to increase economic growth or reduce unemployment is the prospect of weakening business sentiment. This is especially true when the economy is in a recession. When interest rates fall, firms may not increase investment expenditure if they are less optimistic about the economic outlook. If this happens, economic growth will not rise and unemployment will not fall. Although this argument is valid, many students describe this as a situation of interest inelastic investment. This is erroneous. Weakening business sentiment and interest inelastic investment are two different things altogether and the former will not lead to the latter. To understand this, we simply need to examine the concepts of interest elasticity of investment and business investment. Investment is said to be interest inelastic when a change in the interest rate leads to a smaller proportionate change in investment. If investment is interest inelastic, a change in interest rates is unlikely to lead to a significant change in investment. When this happens, the marginal efficiency of investment (MEI) function will be relatively steep. Business sentiment is said to be weakening when firms are less optimistic about the economic outlook. If business sentiment weakens, investment will fall. When this happens, the MEI function will shift leftwards. To put it somewhat differently, interest elasticity of investment affects the steepness of the MEI function but business sentiment affects the position of the MEI function. Therefore, students should not confuse weakening business sentiment with interest inelastic investment.

 

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Principal Economics Tutor: Mr. Edmund Quek