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## Interest Rate - Investment Relationship

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Investment

Investment is the amount of capital goods, buildings and

changes in inventories businesses want to undertake in the current period.

Businesses do things that lead to maximum profit, and

investment is one of those things. In the profit calculation

firms consider the rate of return(revenue side) – call it r - on the investment as well as the cost of capital(cost side) – call it i.

When firms buy capital goods, they typically borrow the

money. So the cost of capital is the real rate of interest iat

which they borrow.

Investment

The rate of return can be thought of in the following way.

When a firm undertakes investment it hopes revenues are

increased, but it also knows expenses to operate the new

stuff will be there.

If we ignore the cost of capital for a moment, the firm

would only even consider those investment projects that

have revenue returns greater than the additional costs of

operation.

What is left is a comparison of the rate of return and the

real interest rate.

Real interest rate = nominal interest rate minus inflation rate.

Examples:

You have a $1 that can earn 10% at the bank this year.

The 10% is the nominal rate, the amount of money you earn by next year.

1) Say a can of coke costs 50 cents today and 50 cents next year. When you give the $1 to the bank you really give up a 2 cokes, but you really get back 2.2 cokes next year. Without inflation the real return on your money is the same as the nominal rate.

2) Say cokes rise in price to 55 cents(10% inflation). Your earning at the bank is wiped out by inflation.

Investment

If the rate of return is greater then the real interest rate, then the project is profitable even when including the interest cost.

In fact our rule will be, the firm should add an investment project whenever the rate of return is greater than or equal to the real interest rate, but never add a project when the rate of return is lower than the real interest rate.

Investment

rates

investment

e d c

In this diagram I want you first to just think of investment projects and rates of return. One project requires spending e dollars of investment as shown. Another requires spending d minus e dollars.

Investment

Part of what I want you to see on the previous graph is that firms have lots of investment (getting new equipment and the like) ideas. The first “chunks” of investment has the highest rate of return, the next chunk has the next best, and so on with investment with lower and lower rates of return.

Analogy: I line the class up in the front of the room and I do it by height, tallest first and then the second tallest, and so on.

On the horizontal axis we lined up investment projects, with highest rate of return investment project first.

rates

If d dollars are spent, then

two projects are undertaken.

Now, the other thing we

want to think about is this:

Firms first

undertake those

projects with the

investment

e d c

the highest rate of return(of course they have to have a

return higher than the real interest rate, we look at that in a minute). So project e is best, then d and then c here.

rates

Now if the real interest rate is i1, only project e has a high enough return for the firm to

be profitable.

i1

investment

e d c

rates

Now if the real interest rate is i2 not only does project e have a high enough return for the firm to be profitable, so does project d.

i1

i2

investment

e d c

With this thinking we can see the downward sloping line

shows the combinations of the real interest rate and investment

levels firms will want to undertake. This line is called the

investment demand line or curve and we see more investment is

undertaken at lower interest rates.

Shifting investment demand

So, we have just seen a major determinant of investment is the real interest rate. Other determinants of investment cause the investment demand curve to shift.

NOTE: Look at the previous slide again, PRETTY PLEASE WITH SUGAR ON TOP! The graph has the interest rate and the investment amount in it.

If the interest rate changes we move along the investment demand line BECAUSE the interest rate is a variable in the graph !

Other things that influence Investment

Other things that influence investment besides the interest rate (and will thus shift the investment demand curve ) are 1) Acquisition, maintenance, and operating costs, 2) Business taxes, 3) technological change, 4) stock of capital goods on hand, and 5) expectations.

Let’s look at each of these ideas next, shall we?

Investment and costs

The rate of return on investment projects is influenced by the costs of the new equipment, operating costs and other costs like maintenance costs.

If these costs go down then more investment projects than before have a rate of return high enough to overcome the interest rate cost. Thus the demand curve would shift to the right.

(Looking back, when costs go down, investment up to level d are now good enough.)

Rising costs have the opposite impact.

Investment and Business taxes

Taxes on business are really a drag! What I mean by this is that businesses want profit and taxes are taking this so higher taxes reduce investment because fewer projects are profitable.

Lower taxes thus increase investment.

Investment and technological change

While new technologies are often expensive, the relevant idea here is that the new technologies also mean so much more can be produced and thus investment is that much more profitable.

Investment and stock of capital on hand

If there is a high stock of capital on hand relative to production, then investment in new capital falls, while if the current stock is being use very intensively then investment rises because more machine and equipment will likely have a decent return.

Investment not only depends on the real interest rate (and given rates of return), but also on the level of expectations businesses have about the future. For us this means how optimistic are firms about their rates of returns on investment projects.

If firms become more optimistic, then they would think rates of returns are going to be higher than they thought previously and thus they would want to invest more, at any real interest rate.

Let’s see what this means in our graphs.

rates

i1

I

e d c

If real the interest rate is i1, then under the initial level of expectations only level e gets undertaken. But if firms become more optimistic about business conditions then the investment demand shifts right, meaning at rate i1 we have more investment undertaken.

The same holds for the other factors mentioned.

In the national economy of the United States consumption is relatively stable from year to year, while investment moves up and down much more. Some say investment is volatile.

One reason for the volatility of investment is linked with the very nature of what is investment. Investment is firms buying new machines and equipment (as well as changes in inventory and housing construction). These machines can last a long time. But some periods if businesses see the world optimistically (expectations are high) they may replace a lot of these machines. Investment would be high that year, but the next year they wouldn’t need as much new machines.

Innovation is about new methods of producing and thinking. With major innovations like railroads in the late 1800’s, mass production in early 1900’s and the computer today we see big jumps in investment in these tools, but after they are in widespread use the investment slows down again.

Firms sometimes retain profit in the business instead of having the owners take the profit. To the extent that there are profits investment is easier to undertake. When profits are low this slows investment down.

Expectations of the business community are also highly flexible thus unstable. When you see the paper daily you see business folks can change their mind in a hurry. This makes investment volatile as well!

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