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Investment Review for AP Economics (page 2)

By — McGraw-Hill Professional
Updated on Mar 2, 2011

Investment and GDP

In the simple model of private investment outlined in Figure 13.5, there is no mention of GDP or disposable income. With no government or foreign sector, GDP = DI. To keep the model simple, we assume that investment spending (I) is determined from the investment demand curve and is constant at all levels of GDP.

Example:
In Figure 13.5 if the interest rate was 5%, firms would invest $20 billion this year, regardless of the level of disposable income or GDP. This autonomous investmentis illustrated in Figure 13.6 as a horizontal line with GDP on the xaxis. If something happened to interest rates, or to investment demand, autonomous investment could increase or decrease, but at that new level, would once again be constant at any value of GDP.

Investment

Investment

Market for Loanable Funds

It is useful to see the relationship between saving and investment by looking at the market for loanable funds.When savers place their money in banks or buy bonds, those funds are available to be borrowed by firms for private investment.

Demand for Loanable Funds

The inverse relationship between investment and the real interest rate is fairly straightforward. As the real interest rate falls, borrowing becomes less costly, and large investment projects become more attractive to firms. This investment demand curve can also be thought of as a demand for loanable funds.

Supply of Loanable Funds

The supply of loanable fundscomes from saving on the part of households (private saving)and government (public saving).If disposable income is greater than consumption, private saving exists, and is positively related to the real interest rate. Public saving is the difference between tax revenue collected by government and dollars spent by government. If government spends more than is collected in taxes, public saving is negative and the supply of loanable funds falls. If government collects more tax revenue than is spent on goods and services, public saving is positive and the supply of loanable funds rises.

The market for loanable funds is shown in Figure 13.7 and the equilibrium interest rate is found at the intersection of the supply and demand curves. In upcoming chapters we investigate the role of this market in the banking system, fiscal and monetary policy, and economic growth.

Investment

  • The supply of loanable funds comes from saving.
  • The demand for loanable funds comes from investment.
  • Equilibrium is at the real interest rate where dollars saved equals dollars invested.

Review questions for this study guide can be found at:

Consumption, Saving, Investment, and the Multiplier Review Questions for the AP Economics

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