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  Investment Spending and building blocks of Flexible-Price Model

Investment Spending:

In the United States nowadays investment spending averages roughly 17% of GDP. However investment spending is the mainly volatile and variable component of GDP. (Note as well that economists’ definition of “investment spending” is possibly not what you think it is; explain how economists define as well as calculate investment spending.)

Variations in economy-wide investment spending have two sources. Primary is the interest rate- the higher the real interest rate tends to the lower is investment spending. A higher real interest rate formulates investment projects more expensive for firms to undertake therefore they undertake fewer of them. Second is business managers’ as well as investors’ confidence--what John Maynard Keynes called their "animal spirits."

To model the inverse relationship among the level of investment spending and the long-term real risky interest rate set investment spending I equivalent to the baseline level of investment (the value of the parameter I0) minus the real interest rate r times the slope-of-the-investment-function parameter Ir:

I = I0 - Ir x r

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