© 2011 Economics Cafe All rights reserved.

Written by: Edmund Quek

(a) What are the determinants of investment expenditure in Singapore?

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(b) Discuss whether an increase in the investment expenditure in Singapore is desirable

for the economy?

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(a) Investment expenditure is the expenditure made by firms on goods produced not

for their present use but for their use in the future. When discussing the determinants of

investment expenditure, it is useful to distinguish between autonomous investment and

induced investment as they have different determinants.

Autonomous investment is the part of investment that does not depend on

national income and is determined by interest rates, business sentiment, business

costs, capital costs, corporate income tax, technological advancements and the

availability of credit. The investment function shows the investment expenditure of

firms at each interest rate. According to the marginal efficiency of investment theory, the

marginal efficiency of investment function is the investment function. A fall in interest

rates will lead to more profitable planned investments resulting in an increase in

investment expenditure and vice versa. An increase in investment expenditure due to a

fall in interest rates can be shown by a downward movement along the marginal

efficiency of investment function.

In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downward

movement along the marginal efficiency of investment function (MEI) resulting in an

increase in investment expenditure (I) from I0 to I1. However, a change in interest rates in

Singapore will not lead to a significant change in the investment expenditure as most of

the investments are made by foreign firms with foreign sources of funds. In Singapore,

the major determinants of autonomous investment are business sentiment and corporate

© 2011 Economics Cafe All rights reserved.

Written by: Edmund Quek

income tax. For instance, the Singapore economy is rather export-dependent due to the

small domestic sector. Therefore, a strong external economic environment of Singapore

will lead to stronger business sentiment. When this happens, expected returns on planned

investments in Singapore will increase which may lead to a large increase in the number

of profitable planned investments and hence the investment expenditure. Most of the

investments in Singapore are made by large foreign firms which earn high corporate

income. Therefore, a decrease in corporate income tax which will increase expected after-

tax returns on planned investments in Singapore may result in a large increase in the

investment expenditure. Although business costs, capital costs, technological

advancements and the availability of credit also affect investment expenditure in

Singapore, they are minor determinants. For instance, business costs and capital costs in

Singapore are generally stable. Therefore, they rarely change substantially. An increase in

investment expenditure due to a non-interest rate factor can be shown by a rightward shift

in the marginal efficiency of investment function.

In the above diagram, a rightward shift in the marginal efficiency of investment (MEI)

function from MEI0 to MEI1 leads to an increase in investment expenditure (I) from I0 to

I1 at the same interest rate (r0).

Induced investment is the part of investment that depends on national

income. According to the accelerator theory of investment, net investment is determined

by the rate of change of national income. When national income rises at an increasing

rate, net investment will increase. However, when national income rises at a decreasing

rate, net investment will decrease. The size of the accelerator effect depends on the

capital-output ratio. The higher the capital-output ratio, the larger the accelerator effect.

In Singapore, the capital-output ratio is high and hence the accelerator effect is large.

In conclusion, investment expenditure is a volatile component of aggregate

demand in Singapore. Therefore, the Singapore government should control investment

expenditure to maintain the good health of the economy.

© 2011 Economics Cafe All rights reserved.

Written by: Edmund Quek

(b) The effects of an increase in the investment expenditure in Singapore on the

economy can be discussed in terms of the effects on the balance of payments, the national

income, unemployment and the general price level.

An increase in the investment expenditure in Singapore may lead to an

improvement in the balance of payments. The balance of payments is a record of all

the transactions between the residents of the economy and the rest of the world over a

period of time and is made up of the current account and the capital and financial account.

If the increase in investment expenditure in Singapore is due to an increase in inward

foreign direct investments, the capital and the financial account and hence the balance of

payments will improve.

An increase in the investment expenditure in Singapore will lead to an

increase in the aggregate demand and hence the national income. Aggregate demand

is the total demand for the goods and services produced in the economy over a period of

time and is comprised of consumption expenditure, investment expenditure, government

expenditure on goods and services and net exports.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to

an increase in national income (Y) from Y0 to Y1. When aggregate demand rises, firms

will employ more factor inputs to produce more output and hence pay more factor

income to households. Household income and hence consumption expenditure will rise.

Due to the increase in consumption expenditure, firms will employ even more factor

inputs to produce even more output and hence pay even more factor income to

households. Household income and hence consumption expenditure will rise further.

Therefore, an increase in aggregate demand will lead to a larger increase in national

income and this is commonly known as the multiplier effect.

© 2011 Economics Cafe All rights reserved.

Written by: Edmund Quek

Since national income is equal to national output, the increase in the national

income of Singapore due to the increase in the aggregate demand will lead to a rise

in the demand for labour resulting in a fall in unemployment, assuming the size of

the labour force remains the same.

An increase in the investment expenditure in Singapore will lead to a more

rapid increase in the aggregate supply in the long run. When the investment

expenditure in Singapore rises, the production capacity will rise more rapidly in the long

run, assuming the net investment is initially positive. Therefore, the aggregate supply in

Singapore will rise more rapidly in the long run. Aggregate supply is the total supply of

goods and services in the economy over a period of time. When this happens, assuming

the aggregate demand in Singapore is rising, which is the normal state of the Singapore

economy, the national income will rise more rapidly, unemployment will be lower and

the general price level will rise less rapidly.

Although an increase in the investment expenditure in Singapore can be

desirable for the economy, it can also be undesirable.

The increase in the aggregate demand in Singapore will lead to a shortage of

goods and services and hence a rise in the general price level. In the above diagram,

an increase in aggregate demand (AD) from AD0 to AD1 leads to a rise in the general

price level (P) from P0 to P1. This is especially undesirable if the Singapore economy is

over-heating.

The increase in the national income and the general price level in Singapore

will lead to a deterioration in the balance of payments. When the national income in

Singapore rises, the imports will rise. Further, the rise in the general price level will make

Singapore’s goods and services relatively more expensive than foreign goods and

services resulting in a decrease in the net exports. Therefore, the current account and

hence the balance of payments of Singapore will deteriorate.

If the increase in investment expenditure in Singapore is due to an increase

in inward foreign direct investments, outward profit remittances will increase in the

long run which will cause the current account and hence the balance of payments to

deteriorate.

In the final analysis, an increase in the investment expenditure in Singapore is

likely to bring about more benefits than costs to the economy. An increase in the

investment expenditure in Singapore will lead to higher economic growth both in the

short run and in the long run. Although inflation in Singapore will be higher in the short

run, it will be lower in the long run. However, due to several factors such as the

emergence of several developing economies with lower labour cost as manufacturing

powerhouses, any increase in the investment expenditure in Singapore is likely to be

small. Further, investment expenditure is a small component of aggregate demand in

Singapore. Therefore, the effect of an increase in investment expenditure on aggregate

demand is likely to be small in Singapore.