Investment and Aggregate Demand

Readers Question: What are the effects of increased investment on aggregate demand in the short term and the long term.

  • Investment means capital expenditure (e.g. purchasing machines or building bigger factory)
  • Investment is a component of AD. – AD+ C+I+G+X-M.
  • Investment spending takes about 15% of AD; it is not as significant as consumer spending which is 66%.

If Investment increases, then ceteris paribus, AD will increase.

AD

However, it depends on the economic circumstances. e.g. if there was a situation of falling house prices and lower consumer spending, increased investment may be insufficient to increase AD.

In the long term, higher investment may increase productive capacity and increase aggregate supply. Therefore, you could argue, investment enables a more sustainable increase in AD. The increase in capacity, enables a sustained rise in AD. If the economy is at full capacity and AD rises then there will be just inflation.

 

Multiplier Effect

If there is spare capacity in the economy, an increase in investment could cause a knock on effect throughout the economy. The initial increase in investment causes a rise in output and so people gain more income, which is then spent causing a further rise in AD. With a strong multiplier effect, there may be a bigger increase in AD in the long-term.

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