Macroeconomics Unit III: Interest Rates and Investment Demands

INTEREST RATES & INVESTMENT DEMANDS

What is investment?

• money spent on expenditures such as:
• new plants (factories)
• technology (hardware and software)
• capital equipment (machinery)
• new homes
• inventories (goods sold by producers)

Expected Rates of Returns

How does business make investment decisions?

• cost/benefit analysis

How does business determine the benefits?

• expected rate of return

How does business count the cost?

• interest costs

How does business determine the amount of investment they undertake?

• compare expected rate of return to interest cost
• expected return > interest cost, then invest
• expected return < interest cost, then do not invest

Real (r%) vs. Nominal (i%)

• Nominal is observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto.
• π% = inflation rate

How do you compute the real interest rate (r%)?

• r% = i% - π%

What determines the cost of an investment decision?

• the real interest rate (r%)

Investment Demand Curve (ID)

Shape?

• downward sloping

Why?

• when interest rate is high, fewer investments are profitable
• when interest rate is low, more investments are profitable

Shifts in Investment Demand (ID)

1. Cost of Production

• lower cost ID →
• higher cost ID ←

      2.  Business Taxes

• higher taxes ID ←
• lower taxes ID →

      3.   Technology Change

• new technology ID →
• no new technology ID ←

      4.   Stock of Capital 

• if an economy is low on capital ID →
• if an economy has too much capital ID ←

     5.  Expectations

• positive ID →
• negative ID ←