Investment Review for AP Economics (page 2)
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.
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.
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.
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.
- 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.
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