2.2.3 Investment — Practice Questions
Seven original multiple-choice questions on investment, written to the style and difficulty of Edexcel Paper 2 Section A. One is a calculation.
Not read the notes yet? Start with the 2.2.3 Investment revision notes.
9 questions in this set
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1. A firm spends £3.5 million on new machinery during a year. Over the same year, £900,000 of its existing machinery wears out. Net investment is
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Answer: B (£2.6m). Net investment = gross investment − depreciation.
£3.5m − £0.9m = £2.6m.
Gross investment is the whole £3.5m spent. But £0.9m of it merely replaces machinery that has worn out, so only £2.6m is a genuine addition to the capital stock.
That distinction is what matters for the long run: an economy whose gross investment only matches depreciation is standing still, however large the spending figure looks.Why the other options are wrong
- A — £0.9m is depreciation — the capital used up, not the capital added.
- C — £3.5m is gross investment. It is the total spent, before allowing for what had to be replaced.
- D — This adds depreciation instead of subtracting it. Wear and tear reduces the capital stock, so it cannot increase net investment.
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2. Capital goods lose value over time through wear and tear and through becoming obsolete. Economists call this
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Answer: B (Depreciation.). Depreciation, also called capital consumption, is the loss of value of capital goods over time — machinery wearing out, and equipment being overtaken by something better.
It is the figure that separates gross from net investment. An economy has to invest enough each year simply to cover it before any of its spending starts adding to productive capacity.Why the other options are wrong
- A — Deflation is a sustained fall in the general price level. The word describes prices across an economy, not the wearing out of machines.
- C — Disinvestment is a reduction in the capital stock, which is what happens when investment fails to cover depreciation. It is a consequence rather than the process itself.
- D — Net investment is gross investment minus depreciation. It is what is left over, not the loss being subtracted.
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3. Firms delay investment projects despite low interest rates and healthy order books, because managers simply feel uneasy about the years ahead. Keynes called this influence
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Answer: B (Animal spirits.). Animal spirits is Keynes's term for the role of emotion, intuition and general sentiment in business decisions — the part of investment that no calculation explains.
The stem is constructed so nothing measurable accounts for the delay: borrowing is cheap and orders are strong. What is left is how the managers feel about a future they cannot see. This is a large part of why investment is the most volatile component of aggregate demand, and why confidence surveys are watched so closely.Why the other options are wrong
- A — Access to credit is about whether banks will lend. The stem says rates are low and gives no suggestion that finance is unavailable.
- C — Regulation is a concrete constraint on what firms may do. Nothing in the stem points to a rule standing in the way.
- D — The rate of economic growth shapes expected future demand, and healthy order books suggest that demand is there. The hesitation is not coming from the data.
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4. A central bank cuts interest rates sharply. For a firm weighing up whether to build a new factory, the most direct effect is that
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Answer: C (The cost of borrowing to fund it falls.). Most investment is financed by borrowing, so the interest rate is effectively the price of the project. A lower rate reduces the return the factory has to earn in order to be worth building, so projects that were marginal become viable.
There is a second route worth noting: even a firm funding the factory from its own reserves faces a lower opportunity cost, because leaving the money in the bank now earns less. Both push the same way.Why the other options are wrong
- A — Consumer confidence may well improve eventually, and stronger demand would encourage investment. But that is an indirect and slower channel than the cost of finance.
- B — Depreciation depends on wear and obsolescence. Interest rates have no bearing on how fast machinery wears out.
- D — Existing machinery is unchanged. What has changed is the cost of acquiring more.
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5. A firm builds a new factory. The spending raises aggregate demand at once. Its second, later effect is to
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Answer: D (Shift long-run aggregate supply to the right.). Investment is unusual in acting on both sides of the model, at different times.
In the short run it is a component of aggregate demand: the money spent on building the factory is demand for construction, materials and labour, so AD shifts right.
In the long run the finished factory adds to the capital stock, so the economy can produce more. LRAS shifts right.
That combination is what makes investment the route to non-inflationary growth: demand and capacity both rise, so output can expand without the same pressure on prices.Why the other options are wrong
- A — More capital means more to wear out, so depreciation in absolute terms tends to rise rather than fall.
- B — The spending raises AD once, when it happens. There is no second demand effect from the same outlay.
- C — This has the direction backwards. Adding to the capital stock raises productive potential.
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6. Table 1 lists four developments facing firms in an economy.
Using Table 1, the development most likely to reduce investment isTable 1: Four developments facing firms Development Development 1 Banks tighten their lending criteria sharply Development 2 The government introduces tax relief on new equipment Development 3 Export orders from abroad rise strongly Development 4 Business surveys report rising optimism Show model answer
Answer: A (Development 1.). Access to credit is one of the main influences on investment, and it is separate from the price of credit. A firm facing tighter lending criteria may be unable to borrow at any rate.
Tighter criteria therefore cut investment directly, and they bite hardest on smaller and newer firms with less security to offer. The other three developments all point the other way.Why the other options are wrong
- B — Tax relief on new equipment lowers the effective cost of capital, so it encourages investment. Government incentives are a recognised influence.
- C — Stronger export orders give firms a reason to expand capacity to meet the demand, which raises investment.
- D — Rising business optimism is among the strongest drivers of investment, since decisions rest on expectations about the future.
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7. Investment swings far more sharply over the economic cycle than consumption does. The best explanation is that investment decisions
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Answer: C (Get postponed when the future looks uncertain.). The asymmetry comes from what each kind of spending is for. Households cannot postpone eating, heating or travelling to work, so consumption has a floor beneath it however bad the outlook.
A new factory has no such floor. It can wait a year, or five, at almost no immediate cost — and since the decision rests on expectations about a future nobody can see, a darkening outlook is reason enough to wait. When confidence returns, the postponed projects arrive together.
That is why investment falls hardest in a recession and rebounds hardest in a recovery, despite being only about 14% of aggregate demand.Why the other options are wrong
- A — Who takes the decision does not by itself make it volatile. What matters is that the decision can be deferred and rests on an uncertain future.
- B — Investment responds to expected demand and the cost of finance. The price level is not the driver, and in any case consumption faces the same price level.
- D — Consumption is much the largest component, at around 60% against investment's 14%. Size is a separate matter from volatility in any case.
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8. A firm's sales grow by 4% one year and by 6% the next. Its spending on new machinery jumps by far more than 6%. This disproportionate response of investment to a change in demand is called the
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Answer: A (Accelerator effect.). The accelerator effect is the idea that investment depends on the rate of change of demand rather than its level.
A firm needs a certain stock of machinery to serve a given level of sales. When sales accelerate, it needs not only the machines to serve the higher level but extra machines to serve the increase — so a modest change in demand produces a much larger change in investment.
This is a large part of why investment is the most volatile component of aggregate demand, and why it turns down before sales do.Why the other options are wrong
- B — Animal spirits is Keynes's term for the role of sentiment and intuition in investment decisions. Here the firm is responding to actual sales figures, not to a mood.
- C — The multiplier works the other way round: an initial injection of spending raises national income by a larger amount through successive rounds.
- D — The wealth effect links the value of assets households hold to their consumption. It concerns households rather than firms' capital spending.
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9. Because investment responds to the rate of change of demand rather than to its level, a slowdown in the growth of sales can
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Answer: D (Reduce investment while sales are still rising.). This is the accelerator's most counter-intuitive implication, and it is worth working through slowly.
Suppose sales grow 6% one year and 3% the next. Sales are still rising — but they are rising more slowly, so the firm needs fewer additional machines than it did last year. Investment falls while sales grow.
Investment therefore turns down before demand does, which is one reason capital spending is a leading indicator of recession and why the investment cycle is so much sharper than the cycle in output.Why the other options are wrong
- A — Falling sales mean the firm needs a smaller capital stock, not a larger one. Investment would fall further still.
- B — The whole point of the accelerator is that investment is highly sensitive to changes in demand rather than insensitive to them.
- C — The accelerator makes investment more volatile than consumption, by amplifying changes in demand rather than damping them.