Investment Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: The Decision to Invest, Investment Demand, Investment and GDP, Market for Loanable Funds
Investment is the other source of private spending. We spend a little time examining why firms increase or decrease investment, build the investment demand curve and then introduce the market for loanable funds.
Decision to Invest
The decision of a firm to spend money on new machinery or construction is simply a decision based upon marginal benefits and marginal costs. The marginal benefit of an investment is the expected real rate of return (r) the firm anticipates receiving on the expenditure. The marginal cost of the investment is the real rate of interest (i), or the cost of borrowing. Let's look at this concept with examples.
Expected Real Rate of Return
A local pizza firm invests $10,000 in a new delivery car. The owner expects this to help to deliver more pizzas, increasing revenues and profits. The car lasts exactly one year and the increased real profits are anticipated to be $2000. This expected real rate of return is $2000/$10,000 = .20 or 20 percent. Of course an actual car lasts more than one year, but this decision to invest is shown for one year to keep it simple, while still making the point.
Real Rate of Interest
The owner goes to the bank and asks for a one-year loan to purchase the new delivery car. The bank offers a nominal rate of interest of 15 percent; this includes 5 percent for expected inflation and 10 percent as the real rate of borrowing the money for a year. At the end of the year, he spends $1000 as real interest on the $10,000 loan.
Since the new delivery car provides $2000 in additional real profits (r = 20%), and the loan costs $1000 in real interest (i= 10%), this investment should be made. Another way to make this decision is with a comparison of interest rates.
Like any demand curve, the quantity demanded increases as the price falls. The same is true for 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 (i= r). Very few investment projects are available at extremely high rates of return and so those opportunities are taken first. As the real rate of return (r) falls, those very profitable opportunities are gone, but many less profitable investments remain. 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. Either way, as interest rates fall, the total amount of investment rises. Figure 13.5 illustrates the investment demand curve, which shows the inverse relationship between the interest rate and the cumulative dollars invested. At an interest rate of 5 percent, $20 billion dollars might be invested.
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