CA Foundation · Business Economics · Business Cycles
During a recession, Indian manufacturer Kaveri Appliances finds that its unsold inventories are rising and it cancels orders for new machinery. In business cycle analysis, which of the following best explains why a fall in investment spending tends to cause a larger fall in national income?
A fall in investment reduces income of those producing capital goods, who then cut consumption, reducing others' incomes in turn. This chain reaction is the multiplier working in reverse, so the total fall in national income is larger than the initial fall in investment spending.
- AThe multiplier works in reverse, so an initial fall in autonomous spending leads to a magnified fall in incomeCorrect
- BLower investment automatically raises consumption and so offsets the fall in income
- CPrices of capital goods rise, which increases the demand for machinery
- DGovernment tax revenue rises during recession, which boosts aggregate demand
Explanation
A fall in investment reduces incomes of workers and suppliers of capital goods. They cut their own consumption, which lowers incomes further in successive rounds. This is the multiplier operating in reverse. The other options describe effects that do not occur in a recession: consumption does not rise automatically, and tax revenue generally falls.
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