Gross Domestic
Investments
Yesterday we
looked at the
consumption Consumption
function
model, which is $530
510
simply the
490
aggregate
470
expenditure
450
model using
430
consumption 410
(in CIGX) only.390
(C = DI)
C
370
45
o
o
370
390
410 430 450
470
490 510 530 550
Disposable
income
Now let’s add gross domestic investments to the
topic and see how it will affect aggregate
expenditures.
C + Ig
$530
510
C
490
470
Ig = $20 Billion
450
430
410
C =$450 Billion
390
370
45
o
o
370
390
410 430 450
470
490 510 530 550
Real GDP
Investment:
• Gross Domestic Investments (Ig) – the
expenditures on new capital goods for future
production.
• Businesses will invest in new capital goods if the
investment project(s) is profitable for the company.
• Marginal benefits = the expected rate of return
(profit) a business expects from its investment.
• Marginal cost = the expected cost of making the
investment. (purchase cost + interest rates).
• Businesses will invest if MB >or = MC.
Let’s say we have a company that generates a yearly profit of
$100,000. We want to invest in a new drill press that will cost
the company $9,000, and it will have a life of only one year.
The company expects that the new drill press will increase the
company’s productivity by 10%.
Marginal cost = $9,000
Marginal benefit = $10,000
(10% increase of $100,000)
Yes, the company undertakes the investment opportunity.
But what if the company has to borrow the money from a bank
in order to make the investment. In that case the interest paid
on the borrow loan is also part of the marginal cost of the
investment. Since interest rates are the cost of borrowing
money.
IR = Marginal cost of Ig.
Should the
Equipment be
purchased?
Let’s say that an investment loan of $9,000 will carry a 12%
interest fee.
The interest on the loan will increase the marginal cost of this
investment by $1080.
(9,000 x .12 = 1,080)
Making the total marginal cost $10,080.
($9,000 + 1,080 = $10,080)
It appears that the company will not make the investment.
But, if you remember back to the lesson inflation, the affects
of inflation helps borrowers. Borrowers pay back money that
has less value. It is the real interest rate (RIR) that is true cost
of borrowing money.
12%
9%
Nominal
Interest
Rate
3%
Anticipated
Inflation
=
Real
Interest
Rate
Should the
Equipment be
purchased?
If the real interest rate (RIR) is the 9%, then the marginal cost
of this investment has only increased $810. Making the total
Marginal cost $9,810.
(9,000 + 810 = $9,810)
It appears that the company will make the investment; because
the marginal benefit is still $10,000.
Lowering interest rates make the marginal
benefits Of capital investments more profitable
for businesses. This will increase the demand for
money to make gross domestic investments. As
RIR decreases the demand for Ig will increase.
There is an inverse relationship between (rir) and Qm
We can illustrate this inverse relationship between real interest
rates and the quantity of money by using an “investment
demand model”.
Investment Demand Model
RIR
16
14
12
10
8%
6
4%
2
0
DIg
5
10
15
20 25 30 35
QM
QM
40
Qm
The quantity of money demanded for
investments increases as interest rates
decrease. This is illustrated as a movement
from point (A) to point (B) on a fixed
investment demand curve. Businesses
borrow more quantity of money because it is
cheaper to do so.
RIR16
14
12
10
A
8%
6
B
4%
2
0
DIg
5
10
15
20 25 30 35
QM
QM
40
Qm
RIR
25%
20%
15%
10%
5%
DIg2
DIg1
50 100 150 200 250 Qm
But sometimes the entire demand curve can shift and change
the entire demand for Ig. Such changes occur without any
change in interest rates. One of five non-interest rate factors
(determinants) has caused this change. Known as taste.
0
Non-interest rate determinants;
• Technology; the development of new technology shifts the
investment demand curve to the right, as businesses upgrade.
• Acquisition of operation cost; when production cost fall,
expected rates of return from prospective investments rise
shifting the demand curve to the right.
• Stock of inventory; businesses with dwindling inventories
will invest in expansion, thus shifting the demand curve right.
• Taxes; lower business taxes increases the expected
profitability of investments, and shift the demand curve right.
• Expectation; optimism about future profits increase
investments and shift the demand curve right.
Volatility of Investment
R R
R
R R
R
R
Investments are very volatile (hard to predict). Just because interest rates
are lowered does not mean that businesses will increase their investments
of capital goods. The reason is because of DIE!
Reasons for Investment Volatility
•Durability of Capital; some
machines are more durable than
other. The more durable them
capital the less need for
replacing it.
•Irregularity of innovations;
its hard to predict when the
next new invention will
occur.
•Expectations; pessimism about
future profits will cause firms to
keep older equipment and avoid
investment.