Unit 3: Interest Rates and Investment Demand

Interest Rates and  Investment Demand

What is Investment?

Definition: Money spent or expenditures on:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• Inventories(goods sold by producers)

Expected Rates of Return

1. How does business make investment decisions?
1. Cost/ benefit analysis
2. How does business determine the benefits?
1. Expected rate of return
3. How does business count the cost?
1. Interest costs
4. How does business determine the amount of investment they undertake?
1. Compare expected rate of return to interest cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest

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

What’s the difference?

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

1. How do you compute the real interest rate (r%)?
1. Formula: r% = i% - pi%
2. What then, determines the cost of an investment decision?
1. The real interest rate (r%)

Investment Demand Curve (ID)

1. What is the shape of the Investment demand curve?
1. Downward sloping
2. Why?
1. When interest rates are high , fewer investments are profitable, when interest rates are low, more investments are profitable.

Shifts in Investment Demand (ID)

• Cost of Production
• Lower costs shifts ID right
• Higher costs shifts ID left
• Business Taxes
• Lower business taxes shifts ID right
• Higher business taxes shifts ID left
• Technological Change
• New technology shifts ID right
• Lack of technological change shifts ID left
• Stock of Capital
• If any economy is low on capital, then ID shifts right
• If any economy has much capital, then ID shifts left
• Expectations
• Positive expectations shift ID right
• Negative expectations shifts ID left