In which of the following circumstances is expansionary...

In which of the following circumstances is expansionary fiscal policy more likely to lead to a short-run
increase in investment? Explain.
a. When the investment accelerator is large or when it is small?
b. When the interest sensitivity of investment is large or when it is small?

Key Concepts

Expansionary Fiscal Policy

This refers to government actions, typically through increased public spending or tax cuts, that are intended to stimulate overall economic activity. In the short run, such policies boost aggregate demand, leading to higher output and income. The expectation is that increased income can further elevate private investment through various channels, including the accelerator effect.

Investment Accelerator

The investment accelerator effect describes the phenomenon where changes in aggregate demand result in an amplified change in private investment. A larger accelerator implies that even a small increase in output can lead to a relatively larger increase in investment spending, making expansionary fiscal policy more effective in increasing short-run investment levels.

Interest Sensitivity of Investment

This concept refers to how responsive investment spending is to changes in interest rates. If investment is highly interest sensitive, an increase in interest rates (often a result of increased demand for funds when fiscal policy is expansionary) could significantly dampen investment. Conversely, if investment is less sensitive to interest rate changes, the potential negative effects of rising rates on investment are much smaller, allowing expansionary fiscal policy to have a more positive impact on short-run investment.

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