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?
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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
Real GDP determines investment
because it is a measure of the level
of demand for the product.
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.
How to invest…
In order to make an investment, business can
do a few things:
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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
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.
Visual 3.6
Macroeconomics Unit 3
And now…
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Some resources:
http://www.reffonomics.com
Works Cited
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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.