What this lesson teaches
I can explain how changes in the determinants of C, I, G and (X - M) shift aggregate demand.
Syllabus 9570, 3.1.2(b). Aggregate Demand and Aggregate Supply: How AD is affected by changes in the determinants of C, I, G and (X - M)
Make a guess
Interest rates fall sharply. A factory already has idle machines and expects fewer orders next year. Will it invest more?
- Probably not, because it expects weak sales.
- No, because lower rates mean banks refuse to lend.
- Yes. Lower interest rates make each new machine cheaper to finance.
Show the answer
Probably not, because it expects weak sales.
Cheaper loans help only when new machines are expected to pay off. With spare capacity and falling orders, there is no reason to buy more.
Consumption depends on income, wealth and confidence; investment depends on expected profits and interest rates.
Consumption depends on disposable income (income after tax), wealth, confidence about the future, and the cost of borrowing.
Investment depends on how profitable firms expect new machines and buildings to be. That depends on expected future sales, business confidence and the interest rate.
Lower interest rates make borrowing cheaper, which can raise both C and I. But they do not work if firms expect weak sales or already have unused machines.
In Singapore, a lot of investment comes from foreign multinationals, which depends on global conditions and Singapore's attractiveness as a location.
- C depends on
- Disposable income, wealth, confidence, interest rates.
- I depends on
- Expected profits, confidence, interest rates, spare capacity.
Worked example: Cheaper loans, but fewer orders
Interest rates fall. But a manufacturer expects fewer orders next year and already has idle machines. Households, meanwhile, feel more secure about their jobs.
- Cheaper loans make investment more attractive.
- But with weak expected sales and spare machines, the manufacturer has no reason to invest.
- So investment may not rise at all.
- Consumption may rise, because confident households spend more.
Watch out for this
Lower interest rates always increase investment.
If firms expect weak demand or have spare capacity, cheap loans may not persuade them to invest.
Check your understanding
Business confidence falls sharply. What is the likely effect on AD?
- Investment falls, so AD shifts left.
- Investment rises, because firms prepare for bad times.
- AD is unchanged, because confidence is not a component of AD.
Show the answer
Investment falls, so AD shifts left.
Right. Firms delay new projects when they expect weaker sales.