Unit 3- Topic 4: Interest Rates and Investment Demand

What is Investment? 

Money spent or expenditures on:

• New plants (factories)
• Capital Equipment (machinery)
• Technology (hardware and software)
• New Homes (homes built that year)
• Inventories (goods sold by producers)

Expected Rates of Return

How does business make investment decision?

• 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 cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest

What then, determines the cost of an investment decision?

• The real interest rate (r%)

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 yield low rates.