'I' as a component of Aggregate Demand

[moshi]

I came across a question today which asks why 'I' fluctuates more than any other component of AD, and couldn't really answer it. Does anybody know the reason why it is more volatile?

[sick muzza]

it is heavily influence by several deman factors, including interest rates, business confidence etc, wheras other components may not be,

[moshi]

true, it is, however, isn't 'C' also affected by factors like interest rates and confidence levels? what makes it more volatile than consumption spending?

[Collin Li]

C has a portion which is very 'inelastic'. We all need a certain level of consumption to live. Investment is not so true. It can fluctuate wildly with the business cycle.

[sick muzza]

im not sure there is a clear cut reason for it. maybe just the fact that firms can put off investment easier than a reduction in consumption, there will always be a certain level due to the needs of society/

[xXNovaxX]

I know a bit late, but I really found this question interesting because I too came across it in my textbook and I would have thought Consumption Spending or "C" is more volatile.

Even the internet and my University textbook didn't offer any explanation :/

But I am going to take a bet. "Sick Muzza" was on the right path

there will always be a certain level due to the needs of society

If you think about it, Australia's population expands ANNUALLY by around 1.70% (or by around 1,000,000 every 5 years according to Census), this means that AD increases for obvious reasons, more people=more demand for g+s=more "I".

"C" volatility is thus lower because population increases every year, that is we don't have 2007=increase in people, 2006, decrease, and vice versa, so its STABLE.

Another reason is when interest rates rise it takes about 18 months for the FULL EFFECT to be felt and even then many households continue spending, it takes like SEVERAL rate rises for people to change their spending patterns, therefore "C" remains STABLE.

Now, for Investment Spending aka "I" they look way into the future. If there is even TALK of a rate rise they adjust their plans, investment production levels etc rapidly.

When a rate rise happens, they begin cost saving, which tends to involve reducing production.

Look at the below example from http://www.historycommons.org/context.jsp?item=financial_crisis_52

the country’s car production plunges a record 41 percent in January and vehicle productions decrease by nearly 50 percent to 576,539 vehicles produced in January 2009 compared with 976,975 in January 2008.

Car production fell by 50% !!!!!!!!!!!! See how fast they switch production? Because remember machines/factories produce stuff rapidly, cars don't take YEARS to produce but a few weeks (i think).

From wikipedia

One is the consumption-investment decision. Since productivity is higher, people have more output to consume. An individual might choose to consume all of it today. But if he values future consumption, all that extra output might not be worth consuming in its entirety today. Instead, he may consume some but invest the rest in capital to enhance production in subsequent periods and thus increase future consumption. This explains why investment spending is more volatile than consumption

I hope this makes sense and is a good reason, this is how I think about it