Interest Rates (i% = nominal; r% = real)

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AP Macroeconomics

• Interest Rates (i nominal r real)
  Investment Demand ID

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What is Investment?

• The decision of a firm to spend money on new
  machinery or construction is simply a decision
  based upon marginal benefits and marginal costs.

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What is Investment?

• The marginal benefit of an investment is the
  expected real rate of return (r)the firm
  anticipates receiving on the expenditure.

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What is Investment?

• The marginal cost of the investment is the real
  rate of interest (i), or the cost of borrowing.

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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

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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 gt interest cost, then invest
• If expected return lt interest cost, then do not
  invest

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Real (r) v. Nominal (i)

• Whats the difference?
• Nominal is the observable rate of interest. Real
  adjusts for inflation (p)and is only known ex
  post facto.
• How do you compute the real interest rate (r)?
• r i - p
• What then, determines the cost of an investment
  decision?
• The real interest rate (r)

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Pizza Example
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Investment Demand

• Like any demand curve, the quantity demanded
  increases as the price falls. The same is true
  for investment demand.

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Investment Demand

• The rational firm invests in all projects up to
  the point where the real rate of interest equals
  the expected real rate of return. (ir)
• Very few investment projects are available at
  extremely high rates of return and so those
  opportunities are taken first.

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Investment Demand

• As the real rate of return (r) falls, those very
  profitable opportunities are gone, but many less
  profitable investments remain.

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Investment Demand

• So as the expected real rate falls, the
  cumulative amount of investment dollars rises.
• Likewise, as the real cost of borrowing (i)
  falls, more and more projects become worthwhile,
  so dollars of investment rises.

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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

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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
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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

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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
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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

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Instability of Investment

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

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Is college a good investment?

• http//www.bostonglobe.com/opinion/2014/02/18/jobs
  -future-will-require-greater-skills-but-not-necess
  arily-degree/12MvSdMvNIJBIBnV6mRGXL/story.html

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