In fact, once you assume that investment equals
autonomous investment and is not determined by
the level of income that means you can draw the investment function as a horizontal line.
Did you get that right? Now, let's ask the bigger question,
does it really makes sense to assume in the Keynesian model that
business investment is autonomous and does not
depend on the level of income like consumption does.
Let's tackle that question by looking at this figure which
depicts the plunge in business investment during the Great Depression.
In this figure, the investment expenditures curve I1,
shows annual business investment in
1929 just prior to the stock market crash at $16 billion.
In contrast the investment expenditures curve I2,
shows investment after it has precipitously fallen to $1 billion by 1933.
So here's a question for you as you look at this figure,
if investment is not determined by the level of income,
what might be the determinants of investment?
Take a minute now to think about that and jot down some ideas before we get
into the mind of John Maynard Keynes for an answer.
So how did John Maynard Keynes see investment expenditures being determined?
To Keynes there were at least two important factors.
First, Keynes quite logically
believe that investment is sensitive to changes in the interest rate.
To Keynes, when interest rates fall,
this fall and the price of financial capital results in an increase in investment.
Contrast when interest rates rise,
investment expenditures fall as it becomes
more expensive to undertake capital investment.
But here's yet another important Keynesian plot twist.
While Keynes believe the interest rate was important in determining investment,
he decidedly did not embrace the classical economists notion
that falling interest rates and increased investment
would necessarily lead back to a full employment equilibrium.
That's what Keynes's second factor driving
investment expenditures comes into play and it's
captured by two of the most famous words in macroeconomics, animal spirits.
Yep, I just said animal spirits.
Just what exactly did Keynes mean by the term animal spirits?
Well, Keynes believed that investment was in large part driven by the expectations or
business confidence that businesses had regarding potential sales and profits.
And if business executives believe the economy was about to go bad,
it could become a self-fulfilling prophecy.
The reason, fearful business executives would cut back on investment and production,
run down inventory levels and possibly lay off people.
And enough fearful executives did that.
These negative animal spirits might indeed help trigger
or at least further amplify a downward recessionary spiral.
And that is precisely why economic forecasters
even today closely watched economic indicators
like business confidence and consumer confidence that
capture the animal spirits of key economic actors.
And here it should be clear that confident businesses will
tend to invest more and confident consumers will tend to spend more.
And that typically means a faster growing economy and a more bullish stock market.
The third component of
aggregate expenditures in the Keynesian model is government spending.
This includes everything from the purchase of missiles,
ships and bombers for national defense to roads bridges courthouses and school yards.
It also includes payment for the services of
the soldiers civil servants and judges and teachers most nations hire.
Unlike private consumption and investment,
this government expenditures component of aggregate demand,
is determined directly by the government's spending decisions.
And as with business investment,
the Keynesian model assumes government expenditures to be autonomous.
That is determined outside the market.
This means algebraically that government expenditures,
G simply equals autonomous government expenditures, G knot.
And as with the investment function,
the government expenditures function can be graphically portrayed as a horizontal line.
In general government expenditures exhibit much less volatility than investment.
Although episodic events such as wars and natural disasters can
lead to huge fluctuations.
Note that in the Keynesian model,
increased or decreased government expenditures together with tax cuts or tax increases,
serve as the primary tools of fiscal policy that are
used to counterbalance changes in investment and consumption spending.
In fact, through a Keynesian lens,
that's how government expenditures are at least partly viewed.
Not just as a means to provide public goods and public works and government services,
but also has a macroeconomic balance wheel that uses
fiscal policy to offset any shortfalls in
consumption or investment that might lead to a recession.
And just to test your knowledge here.
If you are the chief economist of a country
facing a recession and you were a Keynesian disciple,
what would you recommend in terms of discretionary fiscal policy?
Committed now to jot down your answer, before moving on.