Question

Explain how an increase in business investment at a constant price level changes equilibrium expenditure.

Short answer

An increase in business investment raises the equilibrium expenditure.

Step-by-step solution

Identify the components of aggregate expenditure

Aggregate expenditure is the total spending in an economy and is composed of consumption (C), investment (I), government spending (G), and net exports (NX). In this case, focus on the component of investment (I).

Understand the role of investment

Investment is an injection into the economy and increases aggregate expenditure. This is assuming that the price level is constant, so changes in investment directly affect the equilibrium expenditure.

Analyze the relationship between investment and equilibrium expenditure

An increase in business investment increases aggregate expenditure. The equilibrium expenditure is the level at which total spending (aggregate expenditure) equals total output (GDP).

Graphical representation

On a graph where the 45-degree line represents where aggregate expenditure equals output, an increase in investment shifts the aggregate expenditure line upwards. This intersection point with the 45-degree line now occurs at a higher level of output, representing an increase in equilibrium expenditure.

Result

Therefore, at a constant price level, an increase in business investment leads to a higher equilibrium level of output and expenditure.

Key concepts

Aggregate Expenditure

Aggregate expenditure is the total spending in an economy. It includes:

• Consumption (C)
• Investment (I)
• Government Spending (G)
• Net Exports (NX)

Each component represents different types of expenditures. Consumption is what households spend on goods and services.
Investment includes spending by businesses on capital goods like machinery.
Government spending includes all government expenditures on goods and services.
Net exports represent the value of a country’s exports minus its imports.
The sum of these components gives the economy’s total aggregate expenditure.

Equilibrium Expenditure

Equilibrium expenditure is where the total spending (aggregate expenditure) is equal to the total output (Gross Domestic Product or GDP). This balance is crucial for the economy.
When aggregate expenditure rises, for instance through increased investment, it prompts businesses to produce more to meet the new demand. This production increase means higher GDP.
Equilibrium expenditure is found by where the aggregate expenditure line intersects the 45-degree line on a graph. This line represents points where total spending equals total output.
Graphically, any shift in aggregate expenditure due to increased investment will shift the equilibrium point upwards.

Constant Price Level

A constant price level assumes that prices of goods and services do not change. This simplifies the analysis of how investment affects equilibrium expenditure.
If prices stay the same, any change in spending directly affects the quantity of goods and services produced. For example, if businesses invest more, they spend more on capital goods.
This injection of spending increases aggregate expenditure because prices do not rise to offset the increased demand. Thus, quantity supplied increases directly.
This creates a straightforward route from increased investment to increased equilibrium expenditure.

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the total value of all goods and services produced in an economy. It is a measure of the economy's overall health.
GDP can be measured through total output or total spending in the economy. The latter is closely tied to aggregate expenditure.
When businesses increase investment, this boosts aggregate expenditure. Consequently, businesses produce more to meet higher demand, increasing GDP.
Understanding GDP is key because changes in it, driven by changes in any components of aggregate expenditure, reflect significant shifts in economic activity.
Higher GDP indicates a growing economy, enhanced by balanced components of aggregate expenditure.