Why is investment spending the most sensitive component of aggregate demand?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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Investment spending is the most sensitive component of aggregate demand because it is the component that is most optional and most risky.

Aggregate demand is made up of consumer spending, investment, government purchases, and net exports. 

Consumer spending is typically relatively stable.  This is because a high percentage of consumer spending is not optional.  Consumers do not typically have the choice of buying much less food or much less gasoline.  They do not have the choice of forgoing rent payments.  These are things that will not be very sensitive.

Government spending is somewhat stable as well.  The government does not really take risks when it spends.  It is not in serious danger of going bankrupt due to excessive or unwise spending.  Therefore, it can continue to spend even in hard times.

By contrast, business investment is risky and optional.  Businesses can always hold on to cash rather than buying new equipment, so the spending is not mandatory like most consumer spending.  Businesses that overspend on investment in bad times do, unlike the government, run a serious risk of going bankrupt or otherwise hurting themselves.

Thus, investment spending is the most sensitive component of aggregate demand because it is both optional and risky.


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