2026 How the Macroeconomy Works T1W9 Class Test 2 Mark Scheme

T1W9 Class Test 2 How the Macroeconomy Works – Mark Scheme Raffles Institution Economics Department 1 T1W9 Class Test 2 How the Macroeconomy Works Mark Scheme (a) Explain the factors that affect investment. [10] (b) Discuss the effects of a rise in investment on actual and potential growth of different countries. [15] Part (a) Students are expected to explain interest rate and non-interest rate determinants of investments. They are also expected to use examples to substantiate their explanation. Introduction: Define investment : Investment is the act of  acquiring new fixed capital assets like buildings, plants, equipment and machines (known as ‘ fixed capital formation’) by firms, and  the accumulating of stocks and inventories such as raw materials, semi-finished goods and finished goods held by the producer (known as ‘changes in physical stocks’) to be transformed into final goods and services. Factors that affect investments in a country mainly fall under interest rate and non-interest rate factors. The main theory concerning determination of investment is the Marginal Efficiency of Investment. Body: Requirement 1: Interest rate and how it affects 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 (such as purchase of new machinery, expansion of factory space) 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. Decision making from firm’s POV: 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 (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. At a MEI2

T1W9 Class Test 2 How the Macroeconomy Works – Mark Scheme Raffles Institution Economics Department 2 higher rate of interest, if MEI < r, less investment project will be undertaken as they are less likely to be profitable. When interest rate falls from r0 to r1, 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 from I0 to I1, reflected as movement down the MEI curve. Requirement 2: Non-Interest rate factors affecting investment (Provide 2) b) Changes in business confidence and expectations Business con