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) Raising interest rates decreases planned investment spending and increases unplanned inventory investment. b) Higher expected GDP growth increases planned investment spending, with uncertain effects on unplanned inventory investment. c) An inflow of foreign funds lowers interest rates, increases planned investment spending, and could lead to stable or reduced unplanned inventory investment.

Step-by-step solution

Effect of Federal Reserve Raising the Interest Rate

When the Federal Reserve raises the interest rate, the cost of borrowing for businesses increases. This higher cost can dissuade firms from financing new capital, hence reducing planned investment spending. With less planned investment, firms are more likely to have an excess of goods that were not sold, causing unplanned inventory investment to rise.

Influence of Increased Expected Growth Rate of Real GDP

An increase in the expected growth rate of real GDP can lead to an optimistic economic outlook for businesses. This optimism may prompt firms to increase planned investment spending to prepare for the expected rise in demand. As a result, if the actual demand meets these expectations, unplanned inventory investment is likely unchanged. However, if actual demand doesn’t meet expectations, unplanned inventory investment could either increase or decrease depending on the discrepancy.

Impact of Inflow of Foreign Funds Lowering the Interest Rate

An inflow of foreign funds into the country can result in a lower interest rate due to increased supply of loanable funds. Cheaper borrowing costs may encourage businesses to invest more in capital projects, hence increasing planned investment spending. If firms appropriately anticipate the resulting increase in demand, unplanned inventory levels would likely remain stable or decrease if sales exceed expectations.

Key concepts

Income-Expenditure Equilibrium

Understanding how income and expenditure flows interact within an economy is critical for analyzing its stability. Income-expenditure equilibrium occurs when an economy's total output, or gross domestic product (GDP), is equal to total planned spending. In other words, the output produced by businesses is completely absorbed by aggregate expenditure, which includes consumer spending, investment, government spending, and net exports.

When unplanned inventory investments occur, it signifies a deviation from this equilibrium. If businesses overestimate consumer demand, they will produce goods that are not immediately sold, leading to an increase in inventories, which is an unplanned investment. Conversely, underestimating demand results in decreased inventories which, although not immediately a concern, can lead to production ramp-ups later on.

This balance is delicate and can be influenced by various factors such as interest rates, consumer confidence, and expectations of economic growth, as shown in the provided exercise scenarios. A key component in maintaining equilibrium is the alignment of planned investment spending with actual sales and consumer demand.

Federal Reserve Interest Rate Effects

The Federal Reserve (or the Fed) plays a pivotal role in the US economy by setting short-term interest rates. These rates influence the cost of borrowing for consumers and businesses alike. When the Fed increases these rates, they are essentially making loans more expensive, which can discourage spending on large investments and consumption. This is particularly impactful on planned investment spending by businesses.

As borrowing costs rise, companies may postpone or scale down their investment in new projects, equipment, or expansion plans. This decrease in planned investment spending can lead to an increase in unplanned inventory investment, as firms may end up with more stock than forecasted due to decreased sales — consumers and businesses cut back on spending due to higher interest costs. Furthermore, the higher interest rate can attract foreign investors seeking better returns, impacting currency value and international trade balances.

Unplanned Inventory Investment

Unplanned inventory investment is seldom a desired outcome for firms. It arises when businesses accumulate more inventories than intended, often due to a mismatch between expected sales and actual sales. When planned investment spending does not translate into equivalent consumer demand, businesses are left holding excess goods, leading to increased inventories, which ties up capital and can reduce liquidity.

Managing such unplanned inventory levels is crucial as it impacts a firm's financial health and can alter the macroeconomic equilibrium. If widespread across the economy, excessive unplanned inventory investment can signal an upcoming downturn, as it may compel businesses to reduce production, laying off workers, and thus, negatively affecting income and consumer spending. In the scenario where the Fed raises interest rates, an increase in unplanned inventory investment indicates that equilibrium is disturbed, potentially slowing economic activity.

Real GDP Growth Expectations

Expectations of future economic performance, specifically real GDP growth, can have a profound effect on business investment decisions. An anticipated increase in real GDP growth usually suggests a future rise in consumer demand, overall economic activity, and profitability. In response, businesses may boost their planned investment spending to capitalize on this growth, by expanding operations or investing in new technologies to meet the expected increase in demand.

As businesses attempt to prepare for this projected economic expansion, the accuracy of their forecasts becomes critical. If actual growth aligns with expectations, planned investments are justified, and the economy might experience a smooth expansion with stable employment and income growth. However, overestimation of growth can lead to excess inventory, while underestimation can lead to lost sales and market share. The activities of businesses, based on these growth expectations, shape economic cycles of expansion and contraction, underscoring the importance of reliable economic forecasting.