Unit III: Interest Rates and Investment Demand

Interest Rates and Investment Demand

What is Investment?

Money spent or expenditures on

          i.            New plant (factories)

         ii.            Capital equipment (machinery)

       iii.            Technology (hardware and software)

       iv.            New homes

         v.            Inventories (goods sold by producers)

Expected rates of returns

-How does business determine the benefit?

Cost/ benefit analysis

-How does business determine the benefit?

Expected rate of return

-How does business count the cost?

Interest cost

-How does business determine the amount of investment they undertake?

Compare expected rate of return of interest

If expected rate of return > invest cost, then invest

If expected rate of return < invest cost, then do not invest

Real (r%) versus nominal (i%)

Nominal is the observable rate of interest.

Real subtracts out inflation Interest Rates and Investment Demand

What is Investment?

Money spent or expenditures on

          i.            New plant (factories)

         ii.            Capital equipment (machinery)

       iii.            Technology (hardware and software)

       iv.            New homes

         v.            Inventories (goods sold by producers)

Expected rates of returns

-How does business determine the benefit?

Cost/ benefit analysis

-How does business determine the benefit?

Expected rate of return

-How does business count the cost?

Interest cost

-How does business determine the amount of investment they undertake?

Compare expected rate of return of interest

If expected rate of return > invest cost, then invest

If expected rate of return < invest cost, then do not invest

Real (r%) versus nominal (i%)

Nominal is the observable rate of interest.

Real subtracts out inflation (π%) and is the only known ex post facto

r%= i%- π%

computes real interest rate

-What determines the cost of an investment decision?

The real interest rate (r%)

Investment Demand Curve

What is the shape of the Investment Demand Curve?

Downward sloping

-Interest rates high, fewer investment profitable interest rates are low investments are profitable

Shifts in Investment Demand

-cost of production

-Lower cost shifts ID->

-higher cost shifts ID <-

-Business taxes

-lower business taxes ID ->

Higher business taxes ID <-

Technology

-New technology ID ->

-lack of technology change ID <-

Stock of capital

If an economy is low ID->

If an economy capital increases, then ID <-

Expectations

-positive= ID ->

-negative = ID <-