Investment Demand: Determinants of Investment

AP Macroeconomics

Review

The Multiplier shows the total change in aggregate output (real GDP) due to/caused by an autonomous change in spending.

1/(1-MPC)

Where are we going? In this lesson, you’ll learn

about the determinants of investment, or spending by businesses to replace or increase the capital stock

Investment spending in the US changes dramatically from year to year

Keynes referred to this variability as “animal spirits of business”

What is investment?To the economist, investment

is spending on plant and equipment: the machinery and buildings that a firm uses to produce output.

What is it not? Investment is not the purchase of stocks or bonds. It is the actual investment in the physical structure or equipment.

Determinants of Investment

Determinants of Investment

Output Interest Rate

Real GDP Opportunity Cost

Interest rate represents the opportunity cost of using money to buy investment goods. To decide if they should invest, businesses will compare interest rate to expected profit rate of new plant. If the expected profit is > interest rate, then the firm will invest.

Real GDP determines investment because it is a measure of the level of demand for the product.

How to invest…

In order to make an investment, business can do a few things:

Use profits Use retained earnings Borrow

Therefore, as interest rates go down, more investment opportunities will be available and firms will invest more!

Investment Demand

Investment is an inverse function of the interest rate: As the interest rate goes down, the level of investment goes up.

Visual 3.5 Macroeconomics Unit 3

Increase in Investment

This is what happens if businesses decide to spend more on investment goods – output, and therefore Real GDP, rises.

Note: This is the multiplier process at work…

Visual 3.4 Macroeconomics Unit 3

Upward shift in Keynesian model as interest rate goes down…

But by how much will investment increase as the interest rate decreases?This sounds like a job

for…

Elasticity!

Different Elasticities of Demand

Visual 3.6

Macroeconomics Unit 3

How much investment will increase as the interest rate decreases is dependent on elasticity of the investment function.

Two investment functions: IA and IB. IA is more elastic than IB. Thus, the same decrease in the interest rate from r to r1 will result in two different levels of investment, I1 and I2.

And now…

Some resources:

http://www.reffonomics.com

Works Cited

Economics of Seinfeld. http://yadayadayadaecon.com/concept/

Krugman, Paul, and Robin Wells. Krugman’s Economics for AP. New York: Worth Publishers.

Morton, John S. and Rae Jean B. Goodman. Advanced Placement Economics: Teacher Resource Manual. 3rd ed. New York: National Council on Economic Education, 2003. Print.

Reffonomics. www.reffonomics.com.