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Interest Rate and Investment Demand. What is investment? . Money spent on: New Plants (factories) Capital equipment (machines) Technology (Hardware & Software) New homes Inventories (goods sold by producers) . Expected Rate of Return. How does a business make investment decisions?

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Presentation Transcript
what is investment
What is investment?
  • Money spent on:
    • New Plants (factories)
    • Capital equipment (machines)
    • Technology (Hardware & Software)
    • New homes
    • Inventories (goods sold by producers)
expected rate of return
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
real r v nominal i interest
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
investment demand curve
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%

shifts in investment demand id
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%

instability of investment
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