UNIT
3 Macroeconomics
LESSON 2
Investment
Introduction and Description
In the last lesson, the focus was on a simple Keynesian model of the economy and consumption. In this
lesson, the determinants of investment — spending
by businesses to replace or increase the capital stock
— are described. In contrast to consumption,
investment spending in the United States changes
greatly from year to year. Keynes referred to the
cause of the great variability in investment as the
“animal spirits of business.”
Activity 22 presents an opportunity for students to
use knowledge about business investment to determine whether a project should be undertaken and to
calculate the effects of changes in interest rates for
investment functions with different elasticities.
Objectives
1. Define investment.
2. Differentiate between investment in capital
stock and financial investment.
3. Describe the determinants of investment.
4. Explain why changes in the interest rate change
the level of investment.
5. Describe the effects of different interest elasticities of investment demand.
3. Use Visual 3.4 to explain that if the interest rate
goes down, the aggregate expenditure curve in
the Keynesian model will shift up. The multiplier process will work, and real GDP will increase.
Time Required
One class period or 45 minutes
Materials
1. Activity 22
2. Visuals 3.4, 3.5 and 3.6
Procedure
1. Tell the students what this lesson is about. Define
investment. To an economist, investment is
spending on plant and equipment: the machinery and the buildings that a firm uses to produce
output. Investment is not the purchase of stocks
and bonds or any other financial instrument.
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2. Discuss the determinants of investment: output
and interest rate. Real GDP determines investment because it is a measure of the level of demand for the product. Businesses have a range of
investment opportunities; for example, they can
buy a new machine that produces more than an
older machine, or they can build a whole new
factory. A business will calculate the expected
profitability of the investment alternatives. To be
able to make an investment, the business must
have the money. It can use its profits, or retained
earnings, or it can borrow the money. Either way
the interest rate will determine whether the business invests. The interest rate represents the
opportunity cost of using the money to buy
investment goods. To decide whether to invest,
businesses will compare the interest rate to the
expected profit rate of the new plant and equipment. If the expected profit is greater than the
interest rate, firms will invest. Thus, as the interest
rate goes down, more investment opportunities
will be available and firms will invest more. Project Visual 3.5, which shows that investment is an
inverse function of the interest rate: As the interest
rate goes down, the level of investment goes up.
4. The students may ask how much investment will
increase as the interest rate decreases. The
answer depends on the elasticity of the investment function. Project Visual 3.6. There are two
investment functions: IA and IB. IA is more interest 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.
5. Have the students complete Activity 22. Review
the answers with the students.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
LESSON 2 ■ ACTIVITY 22
Answer
Key
Investment Demand
Investment spending consists of spending on new buildings, machinery, plant and equipment. Investment spending is a part of total spending or aggregate expenditures. Any increase in investment
spending would necessarily increase total spending or aggregate expenditures.
Decisions on investment spending are based on a comparison of marginal cost and marginal benefit: If you expect a particular project to yield a greater benefit than cost, you will undertake it. One of
the costs associated with investment spending is the interest expense on borrowed money to engage
in the project.
Part A
1. Figure 22.1 lists the expected cost of various projects and the associated expected benefit. Fill in
the decision column with Yes if you would undertake the project and No if you would not. The
first example has been completed for you.
Figure 22.1
Comparison of Costs and Benefits of Different Projects
Cost
Benefit
Decision
$65
$20
No
$55
$30
No
$45
$40
No
$35
$50
Yes
$25
$60
Yes
2. If interest rates fell and the cost associated with the project fell by $15 at each level, indicate in Figure 22.2 which projects you would undertake. The first example has been completed for you.
Figure 22.2
Comparison of Project Costs and Benefits with Decrease in Costs
Cost
Benefit
Decision
$50
$20
No
$40
$30
No
$30
$40
Yes
$20
$50
Yes
$10
$60
Yes
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
461
UNIT
3 Macroeconomics
LESSON 2 ■ ACTIVITY 22
Answer
Key
Part B
Figure 22.3 lists the dollar value of investment projects that would be profitable at each interest rate.
Figure 22.3
Country A and Country B Investment Data
Interest
Rate
Country A
Investment
Country B
Investment
10%
$10
$70
8
50
75
6
90
80
4
130
85
2
170
90
Figure 22.4
Investment Demand Curves
12%
8
6
4
140
120
100
80
60
40
180
IA
IB
160
2
20
INTEREST RATE
10%
INVESTMENT
(dollars)
3. Plot the investment demand curve for Country A on Figure 22.4 and label it IA.
4. Plot the investment demand curve for Country B on Figure 22.4, and label it IB.
5. Which country would experience the larger increase in the amount of investment spending if
interest rates in each country dropped from 8 percent to 6 percent? Country A
6. How would you characterize the responsiveness of investment spending to the interest rates in
Country A compared with Country B? In Country A, investment demand is more interest elastic.
7. Assuming an MPC of 75 percent, what would be the effect on real GDP in Country A and Country B if real interest rates decline from 8 percent to 6 percent? In Country A, real GDP would
increase by $160 ($40 x 4); in Country B, real GDP would increase by $20 ($5 x 4).
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
LESSON 2 ■ ACTIVITY 22
Answer
Key
8. What conclusions can be reached about the elasticity of the investment demand curve and the
effect a given change in interest rates would have on equilibrium real GDP? The more inelastic
the investment demand, the smaller the impact on investment of a given change in interest rates
and, thus, a smaller impact on real GDP.
9. Looking at the graph you drew, the investment demand curve is downward sloping in both
Country A and Country B. Why does the investment demand curve have a downward slope?
As the interest rate declines, more investment opportunities become profitable because the cost of
borrowing has declined.
Part C
Use Figure 22.5 to help answer questions 10, 11 and 12.
Figure 22.5
INTEREST RATE
Shift in Investment Demand Curve
I
I1
INVESTMENT
10. If interest rates rise, will the investment demand curve shift to a new location? If so, in what
direction? No. A change in interest rates is a movement along the investment curve.
11. The shift in the investment demand curve shown in Figure 22.5 (I to I1) represents a new location for the entire curve. How would you interpret the difference between movement along an
existing investment demand curve and a shift in the location of the curve? A movement along the
curve is caused by a change in interest rates. A shift in the curve results from factors other than
interest rate. For example, business confidence may increase and cause the investment curve to
shift to the right.
12. List two factors that could cause a shift in the investment demand curve as shown in Figure 22.5.
Change in business conditions
Change in expected profitability of an investment project
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
463