Interest Rate and Investment Demand

1. Interest Rate and Investment Demand

2. What is investment? • Money spent on: • New Plants (factories) • Capital equipment (machines) • Technology (Hardware & Software) • New homes • Inventories (goods sold by producers)

3. Expected Rate of Return • How does a business make investment decisions? • Cost/benefit analysis • How does business determine benefits? • Expected rate of return • How does business count the costs? • Interest Cost • How does business determine the amount of investment to undertake? • compare expected rate of return and interest costs • If expected rate of return > interest cost, then invest • If expected rate of return < interest costs, the do not invest

4. Real (r%) v. Nominal (i%) interest • What is the difference? • Real interest subtracts inflation • Only known ex post facto • Computing r% • r%= i% - inflation% • What then, determines the cost of investment demand? • Real interest rate

5. Investment Demand Curve • Downward sloping • Why? • When interest is high then few investments are profitable • When interest is Low then more investments are profitable • Changes in r% causes changes in Ig r% Ig%

6. Shifts in Investment Demand (ID) • Cost of production • Lower costs, ID → • Higher costs, ID ← • Business taxes • Lower tax, ID → • Higher tax, ID ← • Technology change • New technology, then ID → • Lacking technology, then ID ← • Stock of capital • Low on capital, then ID → • High on capital, then ID ← • Expectations • Positive expectations, then ID → • Negative expectations then, ID ← r% Ig%

7. Instability of Investment • Durability • Capital has long lifespan • Once built, there is no immediate need for more • Irregularity of innovation • Not linear • Bursts of innovation & relatively stability • Variability of profits • Subject to competition, cyclical changes, and human management • Variability of Expectations • Shaped by political and social forces

9. Many believe instability of investment is the chief cause of the business cycle