Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Feeling confident enough to invest?


How confident firms are about the future has a large impact on their investment decisions (whether to purchase capital goods). Firms only want to make such purchases in the following circumstances:


They’re confident that the additional goods and services they can produce with the new capital goods are demanded.


They think that their future profits aren’t going to be taxed heavily.


They believe that their capital won’t be taken from them. Although rarely a problem in advanced economies, it’s still a problem in many developing countries.


Short run

In the short run, an increase in firms’ confidence increases investment (I) demand. As we explain in the earlier section ‘Testing your faith: Confidence in the economy’, investment is a component of aggregate demand (AD = C + I + G + NX), so it raises aggregate demand (see Figure 9-4).

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Figure 9-4: Effects of increased investment in the short run.

AD has increased from AD₁ to AD₂. In the short run, because prices are sticky, this change causes the price level to increase slightly from P₁ to P₂ and real GDP to increase from Y₁ to Y₂. The increase in investment demand means that the economy is now producing more output and that more investment is taking place by firms.

Long run

Earlier in the chapter (the ‘Long run’ section under the ‘Testing your faith: Confidence in the economy’ section) we show that in the long run increased demand for consumption (C) has no effect on output (Y), because as the price level rises, SRAS shifts up and to the left until output returns to its natural level. In the case of the impact of additional

investment in the long run, things are different, because the new capital goods increase the country’s productive capacity and therefore increase the natural level of output .

In Figure 9-5, you can see that the new capital goods have shifted long-run aggregate supply from LRAS₁ to LRAS₂. Therefore, output stays higher and the price level has no need to rise further. Thus the increased confidence of firms that led to higher investment is able to increase living standards!

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Figure 9-5: Effects of increased investment in the long run.