Macroeconomics - Cigx and Equilibrium of National Income

c) Explain the factors that determine the level of C or I or G or X. Choose any one. [10]

Investment is the acquisition of new capital goods, which are used as factor inputs in producing other goods. The level of investment is determined by a number of factors which are separated mainly into two parts: the income factor and the non-income factors, which include interest rate, expected rate of returns, business confidence and expectations, cost and efficiency of capital equipment and government policies.

Investment is affected by changes in income. This investment is referred to as induced (endogenous) investment, the part of investment that varies with the level of income. With an increasing rate of increase in national income, we can expect net investment to increase. When greater amounts of income are earned, more firms are willing and able to increase investment. This allows the firms to have greater flexibility in controlling the amount of goods produced. The increase in investment is represented by a movement along the upwards sloping line of the investment-change in income graph.

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All changes in investment level due to non-income factors are represented by shifting of the horizontal investment-income graph. Investment level is also affected by rate of interest. The interest rate is a measure of the cost of borrowing money. With an increase in interest rates, the explicit and implicit cost of investment increases as well. This causes the profit margin to become narrower, ceteris paribus, decreases willingness to borrow money from the bank, and hence results in the decrease in the willingness and ability of firms to invest. On the other hand, decreased interest rates result in higher levels of investment.

However, the above mentioned relationship may not hold true as firms are more motivated by the expected net rate of returns than the level of interest rates. The expected net rate of returns is the difference between the marginal efficiency...