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Chapter 10: Q6. (page 214)

Why is investment spending unstable?

Short Answer

Expert verified

Investment spending is highly volatile because of the variability in expectations, irregular innovations, the durability of capital goods, and volatility of present profits.

Step by step solution

01

Volatility in investment spending because of expectations

Firms invest only when they expect favourable situations for their business. This determines the level of profits.When a firm expects favourable conditions in the future, it will try to take advantage of this and increase investment spending. If the same firm expects unfavourable conditions, it will try to reduce its losses in the future and decrease investment spending.

The future conditions are very volatile. They depend on situations like war, trade barriers, exchange rates fluctuations, political influences, constitutional laws, court jurisdictions, natural disasters, and others. All these factors influence investment decisions.

02

Volatility caused by the irregular innovations

Innovations have strong power to determine the profit levels of the businesses. An innovation increases efficiency and yields a higher level of profits.However, innovations occur very rarely. It takes time to come up with new inventions or discoveries.

Thus, when innovation occurs, the investment rises all of a sudden but eventually lowers after some time.

03

Volatility caused by the durability of capital goods

The durability of capital goods decides the frequency of investment. If the capital goods do not require replacement or maintenance and can be used for a longer time, firms do not invest in the capital goods, while the less durable goods require the firms to invest more frequently.

04

Present profit influence over investment

Present profits spread a sentiment regarding the future expectation from the business. If a business is giving lower returns today, it is generally expected to yield lower returns in the future also. The pessimistic sentiments related to the expected rate of return lower the investment and vice versa. Thus, the present profits make investment more unstable.

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Most popular questions from this chapter

Irving owns a chain of movie theaters. He is considering whether he should build a new theater downtown. The expected rate of return is 15 percent per year. He can borrow money at a 12 percent interest rate to finance the project. Should Irving proceed with this project?

  1. Yes

  2. No

What are the main macroeconomic objectives of a government?

Precisely how do the MPC and the APC differ? How does the MPC differ from the MPS? Why must the sum of the MPC and the MPS equal 1?

Why is the actual multiplier in the U.S. economy less than the multiplier in this chapter’s example?

Assume there are no investment projects in the economy that yield an expected rate of return of 25 percent or more. But suppose there are \(10 billion of investment projects yielding expected returns of between 20 and 25 percent; another \)10 billion yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth. Cumulate these data and present them graphically, putting the expected rate of return (and the real interest rate) on the vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent?
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