1. Gross Domestic Investments

2. o 45 oC 390470 370 390 410 430 450 470 490 510 530 550 $530 510 490470 450 430 410 390 370 Yesterday we looked at the consumption function model, which is simply the aggregate expenditure model using consumption (in CIGX) only. Consumption Disposable income (C = DI)

3. o 45 oC C + I g I g = $20 Billion 390470 370 390 410 430 450 470 490 510 530 550 C =$450 Billion $530 510 490470 450 430 410 390 370 Real GDP Now let’s add gross domestic investments to the topic and see how it will affect aggregate expenditures.

4. Gross Domestic Investments (Ig) – the expenditures on new capital goods for future production. Businesses will invest in new capital goods if the investment project(s) is profitable for the company. Marginal benefits = the expected rate of return (profit) a business expects from its investment. Marginal cost = the expected cost of making the investment. (purchase cost + interest rates). Businesses will invest if MB >or = MC. Investment:

5. Let’s say we have a company that generates a yearly profit of $100,000. We want to invest in a new drill press that will cost the company $9,000, and it will have a life of only one year. The company expects that the new drill press will increase the company’s productivity by 10%.

6. Marginal cost = $9,000 Marginal benefit = $10,000 (10% increase of $100,000) Yes, the company undertakes the investment opportunity.

7. But what if the company has to borrow the money from a bank in order to make the investment. In that case the interest paid on the borrow loan is also part of the marginal cost of the investment. Since interest rates are the cost of borrowing money. IR = Marginal cost of Ig.

8. Let’s say that an investment loan of $9,000 will carry a 12% interest fee. The interest on the loan will increase the marginal cost of this investment by $1080. (9,000 x.12 = 1,080) Making the total marginal cost $10,080. ($9,000 + 1,080 = $10,080) Should the Equipment be purchased? It appears that the company will not make the investment.

9. NominalInterestRate RealInterestRate AnticipatedInflation - 12 % 9%9%9%9% 3%3%3%3% = But, if you remember back to the lesson inflation, the affects of inflation helps borrowers. Borrowers pay back money that has less value. It is the real interest rate (RIR) that is true cost of borrowing money.

10. If the real interest rate (RIR) is the 9%, then the marginal cost of this investment has only increased $810. Making the total Marginal cost $9,810. (9,000 + 810 = $9,810) Should the Equipment be purchased? It appears that the company will make the investment; because the marginal benefit is still $10,000.

11. Lowering interest rates make the marginal benefits Of capital investments more profitable for businesses. This will increase the demand for money to make gross domestic investments. As RIR decreases the demand for Ig will increase. There is an inverse relationship between (rir) and Qm We can illustrate this inverse relationship between real interest rates and the quantity of money by using an “investment demand model”.

12. RIR 16 14 12 10 8 % 6 4 % 2 0 2030 510 15 20 25 30 35 40 QMQM QM QM DIgDIg QmQm Investment Demand Model

13. RIR 16 14 12 10 8 % 6 4 % 2 0 2030 510 15 20 25 30 35 40 QMQM QM QM DIgDIg The quantity of money demanded for investments increases as interest rates decrease. This is illustrated as a movement from point (A) to point (B) on a fixed investment demand curve. Businesses borrow more quantity of money because it is cheaper to do so. A B QmQm

14. QmQmQmQm100 20025% 20 % 15%10%5%050150 250 taste But sometimes the entire demand curve can shift and change the entire demand for Ig. Such changes occur without any change in interest rates. One of five non-interest rate factors (determinants) has caused this change. Known as taste. RIR D Ig1 D Ig2

15. Non-interest rate determinants; Technology Technology; the development of new technology shifts the investment demand curve to the right, as businesses upgrade. Acquisition of operation cost Acquisition of operation cost; when production cost fall, expected rates of return from prospective investments rise shifting the demand curve to the right. Stock of inventory Stock of inventory; businesses with dwindling inventories will invest in expansion, thus shifting the demand curve right. Taxes Taxes; lower business taxes increases the expected profitability of investments, and shift the demand curve right. Expectation Expectation; optimism about future profits increase investments and shift the demand curve right.

16. Voltility of Investment Volatility of Investment R R R R R R R DIE! Investments are very volatile (hard to predict). Just because interest rates are lowered does not mean that businesses will increase their investments of capital goods. The reason is because of DIE!

17. Durability of Capital; some machines are more durable than other. The more durable them capital the less need for replacing it.Durability of Capital; some machines are more durable than other. The more durable them capital the less need for replacing it. Reasons for Investment Volatility

18. Irregularity of innovations; its hard to predict when the next new invention will occur.Irregularity of innovations; its hard to predict when the next new invention will occur.

19. Expectations; pessimism about future profits will cause firms to keep older equipment and avoid investment.Expectations; pessimism about future profits will cause firms to keep older equipment and avoid investment.