Question

Explain how each of the following actions will affect the level of planned investment spending and unplanned inventory investment. Assume the economy is initially in income-expenditure equilibrium. a. The Federal Reserve raises the interest rate. b. There is a rise in the expected growth rate of real GDP. c. A sizable inflow of foreign funds into the country lowers the interest rate.

Short answer

a. The Federal Reserve raises the interest rate. b. There is a rise in the expected growth rate of real GDP. c. A sizable inflow of foreign funds into the country lowers the interest rate. Answer: a. A rise in the interest rate leads to a decrease in both planned investment spending and unplanned inventory investment. b. An increase in the expected growth rate of real GDP results in an increase in planned investment spending and potentially higher unplanned inventory investment. c. A sizable inflow of foreign funds lowering the interest rate causes an increase in both planned investment spending and unplanned inventory investment.

Step-by-step solution

a. The Federal Reserve raises the interest rate

When the Federal Reserve raises interest rates, borrowing becomes more expensive. As a result, firms are less likely to obtain loans to finance new investments. This leads to a decrease in planned investment spending. Additionally, higher interest rates make it more expensive for firms to hold inventory, so firms will try to minimize their unplanned inventory investment. In this case, unplanned inventory investment would also decrease.

b. There is a rise in the expected growth rate of real GDP

When there is an expected increase in the growth rate of real GDP, firms are more optimistic about future demand for their products. Therefore, they are more likely to invest in new capital and inventory to meet the expected increase in demand. This implies an increase in planned investment spending. However, since firms are planning for an increase in demand, they may increase their inventory levels in anticipation. This could result in a higher level of unplanned inventory investment.

c. A sizable inflow of foreign funds into the country lowers the interest rate

When foreign funds flow into the country, the overall supply of funds available for lending increases. This results in lower interest rates, making borrowing more affordable for firms. As a result, planned investment spending is likely to increase. Regarding unplanned inventory investment, lower interest rates make it cheaper for firms to hold inventory. Therefore, firms may be more willing to hold a higher level of inventory, which could result in an increase in unplanned inventory investment.