Unit III: Interest Rates and Investment Demand

Investment- Money spent or expenditures on:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes
• Inventories (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?
• Cost/Benefit analysis
• How does business determine the benefits?
• Expected rate of return
• How does business count the cost?
• Interest costs
• How does business determine the amount of investment they undertake?
• Compare expected rate of return to interest rate
• If expected return > interest cost, then invest
• If expected return < interest cost, then don't invest

Real Interest Rate (r%) v. Nominal Interest Rate (i%)

• What's the difference?
• Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known for ex post factor.
• How do you compute the real interest rate (r%)?
• r% = i% - π%
• What determines the cost of an investment decision?
• The real interest rate (r%)

Investment Demand Curve(ID)

• What is the shape of the ID?
• 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.