Interest Rates & Investment Demand AP Macroeconomics

What is Investment? Money spent or expenditures on: –New plants (factories) –Capital equipment (machinery) –Technology (hardware & software) –New Homes –Inventories (goods sold by producers)

Expected Rates of Return How does business make investment decisions? –Cost / Benefit Analysis (Is the Benefit > the Cost?) How does business determine the benefits? –Expected rate of return ERR = Profit / Cost Profit = Revenue - Cost

Expected Rates of Return How does business count the cost? –Interest costs (Remember, businesses borrow money to invest) 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

Real (r%) v. Nominal (i%) What’s the difference? –The Nominal Interest Rate is the rate that the bank charges. –The Real Interest Rate is the nominal rate adjusted for inflation.

Real (r%) v. Nominal (i%) How do you compute the real interest rate (r%)? Real Interest Rate = Nominal Interest Rate – Inflation Rate r% = i% - π % What then, determines the cost of an investment decision? –The real interest rate (r%) realIf expected return > real interest cost, then invest realIf expected return < real interest cost, then do not invest

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 –Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

27-8 Investment Demand Curve Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (I) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ r and i (percent) Investment (billions of dollars) ID

Investment Demand Curve (ID) Changes in the real interest rate increase or decrease the amount of investment money demanded, this is represented as… Movement along the investment demand curve. Factors that cause businesses to invest more or less when the real interest rate remains the same… shift the demand curve to the right or the left. In general, these are factors that increase or decrease… the expected rate of return.

27-10 r and i (percent) 0 Investment (billions of dollars) ID 0 ID 1 ID 2 Increase in Investment Demand Decrease in Investment Demand Investment Demand Curve

27-11 Investment Demand Curve Shifts of the curve –Acquisition, maintenance, and operating costs –Business taxes –Technological change –Stock of capital goods on hand –Planned inventory changes –Expectations

Volatility of Investment Source: Bureau of Economic Analysis 27-12