Interest Rates (i% = nominal; r% = real) & Investment Demand

= ID

AP Macroeconomics

What is Investment?

• The decision of a firm to spend money on new machinery or construction is simply a decision based upon marginal benefits and marginal costs.

What is Investment?

• The marginal benefit of an investment is the expected real rate of return (r)the firm anticipates receiving on the expenditure.

What is Investment?

• The marginal cost of the investment is the real rate of interest (i), or the cost of borrowing.

What is Investment?

•Businesses/firms borrow to spend money on:– New plants (factories)– Capital equipment (machinery)– Technology (hardware & software)– New Homes– Inventories (goods sold by

producers)including unsold goods

Expected Rates of Return

• How does business make investment decisions?– Step 1. Cost / Benefit Analysis

• How does business determine the benefits?– Step 2. Assess the expected rate of return

• How does business count the cost?– Step 3. Interest costs

• How does business determine the amount of investment they undertake?– 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%) v. Nominal (i%)•What’s the difference?

–Nominal is the observable rate of interest. Real adjusts for inflation (π%)and is only known ex post facto.

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

r% = i% - π%•What then, determines the cost of an investment decision?–The real interest rate (r%)

Pizza Example

Investment Demand

• Like any demand curve, the quantity demanded increases as the price falls. The same is true for investment demand.

Investment Demand

• The rational firm invests in all projects up to the point where the real rate of interest equals the expected real rate of return. (i=r)

• Very few investment projects are available at extremely high rates of return and so those opportunities are taken first.

Investment Demand

• As the real rate of return (r) falls, those very profitable opportunities are gone, but many less profitable investments remain.

Investment Demand

• So as the expected real rate falls, the cumulative amount of investment dollars rises.

• Likewise, as the real cost of borrowing (i) falls, more and more projects become worthwhile, so dollars of investment rises.

Investment Demand Curve (ID)

• What is the shape of the Investment demand curve?

– Downward sloping

• Why?– When interest rates are high, fewer

investments are profitable; when interest rates are low, more investments are profitable (what law is being referred to here?)

– Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

The Investment Demand Curve

r%

IG

ID

Changes in r% cause changes in IG. Factors other than r% may shift the entire ID curve5%

3%

$2 trillio

n

$3 trillio

n

Shifts in Investment Demand (ID)– Cost of Production : examples?

• Lower costs shift ID • Higher costs shift ID

– Business Taxes : examples?• Lower business taxes shift ID • Higher business taxes shift ID

– Technological Change : examples?• New technology shifts ID • Lack of technological change shifts ID

– Stock of Capital : example countries?• If an economy is low on capital, then ID • If an economy has much capital, then ID

– Expectations : examples?• Positive expectations shift ID • Negative expectations shift ID

http://www.reuters.com/finance

Shifts in Investment Demand

r%

IG

ID

4%

$2.5 trillio

n

$3.25 trillio

n

ID1

When investment demand shifts, different levels of gross private investment occur even while r% remains constant

Instability of Investment•Durability

– Capital has a long life-span, therefore once it is built there is no immediate need for further investment

• Irregularity of Innovation– Innovation does not proceed in a smooth linear

fashion, instead there are bursts of innovation followed by periods of relative stability

•Variability of Profits– Profitability is subject to the forces of competition,

cyclical changes in the economy, and human management decisions

•Variability of Expectations– Political, social and natural phenomenon shape our

positive and negative expectations of the future

Instability of Investment

• Many economists believe that investment instability is the chief cause of the business cycle.

Is college a good investment?

• http://www.bostonglobe.com/opinion/2014/02/18/jobs-future-will-require-greater-skills-but-not-necessarily-degree/12MvSdMvNIJBIBnV6mRGXL/story.html