RI 2025+How+the+Macroeconomy+WorksMark+Scheme

T1W9 Class Test 2 How the Macroeconomy Works - Mark Scheme © Raffles Institution 1 T1W9 Class Test 2 How the Macroeconomy Works Mark Scheme (a) Explain the factors that affect investment and exports. [10] (b) Discuss the effects of a rise in investment on actual growth and potential growth of different countries. [15] Part (a) Students are expected to identify and explain 2 determinant s of investments and exports. They are also expected to use examples of substantiate their explanation. Introduction: Definition of key terms: • Investments is the act of acquiring new fixed capital assets like buildings, plants, equipment and machineries by firms (also known as ‘fixed capital formation’). Investment also includes the accumulation of stocks and inventories such as raw materials, semi -finished goods and finished goods held by the producer (also known as ‘changes in physical stocks’). • Exports refer to the spending of domestically produced goods and services by foreigners (export revenue). There are many factors that affect investments and exports in a country. Body: Requirement 1: Explain factors affecting Investment a) Changes in interest rates According to the Marginal Efficiency of Investment (MEI) theory, there is an inverse relationship between interest rate and investment. The MEI refers to the expected rate of return (or profit) of an additional unit of investment while the rate of interest (r) refers to the cost of borrowing. At any instance, there will be many investment opportunities with varying MEI or expected rate of returns. By ranking such investment opportunities from highest to lowest MEI, a downward -sloping MEI curve will be derived as seen in below figure. To decide whether to undertake an investment project, the rational firm will conduct a cost -benefit analysis. A firm will only invest if it makes a profit - meaning that the expected rate of return of investment MEI2

T1W9 Class Test 2 How the Macroeconomy Works - Mark Scheme © Raffles Institution 2 (i.e. MEI) must be greater than or at least equal to the cost of borrowing for investment (i.e. the interest rate). If MEI ≥ r, firms will undertake the investment. If MEI < r, firms will not undertake the investment. When interest rate falls, there will be more investment projects that would yield a MEI or expected rate of return that is greater than or equal to the new lower interest rate and thus cause the level of investment to increase, ceteris paribus. b) Changes in business confidence and expectations Business confidence refers to how optimistic firms are about their future sales and the level of economic activity. Firms form their expectations by looking at the current state of the economy, political factors, and global situation. If firms become more optimistic about future sales and economic activity, they will expect the rate of return on investment