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Understanding Investment Demand and Interest Rates

This article explains the concept of investment demand, the factors that determine investment decisions, and the relationship between interest rates and investment. It also discusses the differences between real and nominal interest rates and the impact of shifts in investment demand. The article concludes by addressing the instability of investment and its implications for the business cycle.

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Understanding Investment Demand and Interest Rates

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  1. Economics Interest Rates (i% = nominal; r% = real) & Investment Demand = ID

  2. 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

  3. 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

  4. 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%)

  5. 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

  6. The Investment Demand Curve Changes in r% cause changes in IG. Factors other than r% may shift the entire ID curve r% 5%  3% ID  IG $2 trillion $3 trillion

  7. 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

  8. Shifts in Investment Demand When investment demand shifts, different levels of gross private investment occur even while r% remains constant r%  4% ID1 ID IG $2.5 trillion $3.25 trillion

  9. 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

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

  11. 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

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