Unit 3: Interest Rates & 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 cost
        • If expected return > interest cost then invest
        • If expected return < interest cost then do not invest 
Real(r%) Nominal (i%)
  • What's the difference??
    • Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex. post facto
  • How do you compute the real interest rate (r%)
    • r% = i% - π%
  • 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 investment are profitable; when interest rates are low, more investment are profitable.
    • Conversely, there are few investments that yield high rates of return, and many that yield low rates of return.

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