Why does prices increase when Investment increases?

Yup, that was the question that kept bugging me for the whole week. Somehow the way the lecturer explains Economics Principles is through the many many curves in the many many model, which sometimes have hidden assumptions.

Ok, it’s not really hidden but certain symbols like r_F or y* assume that it’s Full Employment or Equilibrium.

Ok, maybe I didn’t pay enough attention during the class, but oh well…

Ok, back to the topic. Due to the fact that we’re studying economic models, stuff like Aggregate Demand & Aggregate Supply (Prices vs Output/Income/GDP), Money Demand & Money Supply curves (Interest rate vs Money) are supposed to self-contain all the “truths” about what’s really happening out there.

Therefore, sometimes an explanation for

“Why does interest rate increases (restores) when the demand of money increases?”

is simply…..

“Oh, don’t you see, it’s clearly indicated on the graph.. see as M^d shifts to the right, the intersection point with M^s caused the interest rate to rise from r_1 back to r_F.”

how interest rate affects investment and ultimately price level
how interest rate affects investment and ultimately price level

Ya ya ya! I see it, thanks for pointing it out, I appreciate that, but wait….

“Why does it increase as in what really happened in the economy?”

all I’ve got is

“Oh, it’s really complicated, that’s why we are studying it in Macroeconomics.

“Ah…. I see.”

Enlightenment, not?

So, when I am stumped by “Why does prices increase when Investment increases?”, I was quite worried. I don’t think I’ll be satisfied if it’s another one of those “it’s too complicated” answer.

Fortunately, there’s a logical explanation as to why prices increases when investment increases. (Some parts of the next section involves minor-rephrasing copying from the Economics Text Book)

First, the hidden information that they assume you know when they point it out that investment has increased is that it has increased from an initial status of investment @ full-employment (potential output). {full employment here doesn’t mean ZERO unemployment, it means ZERO cyclical unemployment, there’s still unemployment in the form of structural [mismatch] and frictional [lag time] unemployment.}

As we’ve been told earlier, when investment increases, GDP increases, as GDP = C + I + G + NX. The “I” here is for investments. So as GDP increases, that means the economy is producing at a level above full employment.

What this means is that firms will find it increasingly difficult to hire and retain workers, and unemployment will be below its natural rate. Workers, on the other hand, will find it easy to get and change jobs.

Therefore, firms will raise their wages to attract workers and prevent them from leaving. As one firm raise its wage, other firms will have to raise their wages even higher to attract the workers that remain.

Wah…. wait wait wait… I asked about prices not wages, why you go and explain to me how wages increase? (but somehow it reminds me of the situation of CCA points in NUS, ok I’ve digressed)

Oh, still have more ar……. ok ok….

It just so happens that wages are the largest cost of production for most firms. Consequently, as their labor costs increase, they have no choice but to increase the prices of their products.

However, as prices rise, workers need higher nominal wages to maintain their real wages. (A good illustration of the real-nominal principle:

“What matters to people is the real value of money or income – its purchasing power – not the face value of money or income.”)

This process by which rising wages cause higher prices and higher prices feed higher wages is known as a wage-price spiral. It occurs when the economy is producing at a level of output that exceeds its potential.

Ohhh….. enlightenment….. ::Wunggggggmmmmmmm::

(ok this part onwards is entirely mine)

The more I delve into Economics, the more I feel like I’m part of a LONG RUN experiment. It’s like the many things that happens around you, happens above you without you knowing that it has happened. I’m sure not many people realize that governments, central banks, economist have been experimenting with different Fiscal Policies, Monetary Policies, sometimes Keynes, sometimes Friedman, balancing between Long Run and Short Run, making sure there’s no inflation but at the same time wants GDP to increase, etc etc etc…. Just so that I can have a bowl of wanton mee at $2 dollars when I’m hungry.

Macroeconomics is like one LARGE SCALE experiment where the subject appears to be the whole human population.

Scary eh?

Is there an option to opt-out?

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joshuatj

Digital Preservation #digipres. IT guy at @AFA_Archive Asian Film Archive. Malaysian news. PC games.

14 thoughts on “Why does prices increase when Investment increases?”

  1. I can think of one way to opt out — be completely self sufficient as an individual or as a community not exceeding say, 6 households. Cause if you grow larger than that I think economic effects will start to take place, even if it’s just barter trade. Basically the idea is to eliminate widespread trade.

    1. @tan-ce
      that is not exactly desirable right? Sounds very monastic to me. Especially with the Great Commission and all, we’re called to “Go ye therefore…..”

      Actually I think there’s an even better idea – do it the BORG style. That way, it’s quite hard to have a mismatch of info. ^^

  2. well, it took me some time to really go into the whole thing cuz I basically learn them in BM. >.<
    but yeah. at this level where I'm learning, I always get answer from my teacher saying "remember, what we learn is theoretically logic, but many things are happening out there, so read the book 1st".. but really. this page of yours does help for my macro paper on monday. thanks sifu

    1. @chunchun
      Hmmm… that’s interesting. Whatever that I’ve learned is supposed to be the most basic stuff. My understanding is that all that I’ve learned should have one way or the other been covered by A-levels econs (shouldn’t be too far away from STPM, right?)

      But I really can understand the feeling of learning all that’s theoretical but yet find it hard to apply to what’s really happening out there. I guess the education curriculum really needs some revamping to ensure whatever that we learn is relevant. ^^ Lots of work to be done.

  3. haha at least you actually understood econs. well, if econs is as certain as the laws of physics, we probably won’t be having this recession (or it won’t be that bad)..

  4. Have you found your answer?

    Here’s my take, and as you know, I’m no Econs major… so take my thoughts with a pinch of salt ๐Ÿ™‚ I’ll give it a shot at this question:

    The Investment (I) pertaining to GDP is specifically GDI (Gross Private Domestic Investment – not counting Government Spending). Perhaps, you may already know that there are more or less 3 types:
    [1] Residential (Building & Infcrastructure for staff & equipment),
    [2] Non-Residential (Machinery, Tools for product development/manufacturing or service delivery) &
    [3] some Inventory Nett thingy (Take out stuff from store/stockpile to be used to manufacture/deliver products/service).

    I’m more of a behavioural economist. So, I don’t really subscribe to pure rational or pure irrational economic paradigms. Like in many things, behaviour is an interplay of thoughts & feelings.

    I believe your answer lies in the psychology & behaviour surrounding ‘COST RECOVERY’.

    So, what would you do as a CEO, especially after you have invested in getting a new office, buying new tools & depleted some of your precious stores?

    [1] Of course, you would need to recover costs (as you’re accountable to employees & the board) & hence, pricing mechanisms is often the easiest way out. So… raise the price?
    [2] Often, when you purchase new equipment/tools, you also need to hire the specialists/technicians too to maintain them. So… raise the price?
    [3] Oooh la la! New office/outlet –> more staff, more equipment –> more electricity consumption reflected on balance sheet. So… raise the price?
    [4] Got new cool product now. But… we need to create demand. How? Get PR agency, hire a social marketer, publicity campaign, advertisements (and we don’t want to appear cheap). So… raise the price?
    [5] Sooo… it seems there’s more demand & we’re running out of supplies in our inventory & there’s no way to replenish just in time. Low supply, high demand. So… raise the price?

    Maybe, the next time you have an Econs question that books & graphs seem to be talking ABOUT but not ON it. Here’s my trick: Ask yourself “What would you do as a CEO?”

    Have fun! All the best ๐Ÿ˜€

  5. @Danny Haha, if I’m given the choice I’ll stay in school forever. Sadly that’s not a choice as I have to eat :p.

    @Jason I understood econs? Well, maybe only what the textbook says so far.. and it’s an entry level econs textbook. So ya, whatever that I’ve learned might just be the most ideal situation ever. But taking this module does equipped me with the necessary vocabulary to understand quite a few articles in the newspapers and such. ::happy::

    whoa thanks Ibnur for the awesome comment, I’ll try to digest it slowly, still got 2 papers to go.

    (BTW, to de-stress, I’ve managed to hack some PHP so that comments posted under this post will be auto-imported to my blog over @ joshuatj.com. Nice integration)

  6. Don’t remember much..

    The short of it (I think) is that your investment causes demand (for cement, factory buildings) to rise, but your short term supply curve is still constant. Investment in this case is investment by the private sector (companies) in factors of production (factories, machinery).

    The long:
    http://en.wikipedia.org/wiki/Aggregate_demand
    Look at Section: Aggregate demand-aggregate supply model
    Aggregate Demand (AD)
    Aggregate Supply (AS)
    You have a Demand and Supply model.
    In your case, investment is defined as part of AD for macroeconomics (economics of large entities like countries)
    AD = C + I + G + X – M
    The “I” is this case seems to be the “investment” you are asked to refer to. I is gross private investment (not government investment). An example of this is when companies invest in more machinery or factory construction which enable them to produce more goods and services to sell.
    Hence, when you increase investment, you increase AD. The demand curve (AD) shifts to the right or goes higher. The economy wants to pay more for the same unit (level) of goods and service.
    Demand curve shifting right and up will intersect the supply curve (AS) at a higher price relative to the same output consumed.

    (I think so..)

    The reason why your AS does not shift to the right is because this is a short term AS. Although your “investment” is used to buy more factors of production, there is a time delay before they can used to produce output of goods and services. This means that although you spent money building your factory, your factory is still not producing goods yet. Hence, in the short term, the AS curve stays constant.

What do you think?