Unit 3: Investment Demand; Real v. Nominal

Investment Demand:

What is an Investment Demand?

• The lower loans demanded the higher the interest rate

• The higher loans demanded the lower the interest rate

• In the U.S. interest rates are a cost of borrowing money

• Reasons to barrow:

  - business 

  - mortgage

  - education

What is Investment?

Money spend or expenditures on:

  • New plants (factories)

  • capital equipment

  • technology (hardware and software)

  •  new homes

  • inventories (goods sold by producers)

Expected Rates and Return

How does business make investment decision?

cost / benefit analysis

How does business determine benefits?
expected rate of return

How does business count the cost?

interest cost

How does business determine the amount of investment they under take?

• compare expected rate of return interest cost

  - if expected return > interest cost, then invest.

  - if expected return < interest cost, then do not invest.

Investment Demand Curve

What is the shape of the investment demand curve? 

Downward sloping

Why?

when interest rates are high, fewer investment are profitable; when interest rates are low, more investment are profitable. 

Shifts in Investment Demand:

1) Cost production

    • lower costs shifts ID -->

    • higher costs shifts ID <--

2) Business Taxes

    • lower business taxes shift ID -->

    • higher business taxes shift ID <--

3) Technological Change

    • New technological change shift ID -->

    • lack of technological change shift ID <--

4) Stock Capitals

    • If an economy is low on capital, then ID -->

    • if economy has much capital, then ID <--

Real v. Nominal

What is the difference?

- Nominal is the observable rate of interest

- real subtracts out inflation 

How do you compute real interest rate (r%) ? 

r% = i% - π%

What then, determine the cost of an investment decision? 

- the real interest rate (r%)