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Chapter 10: Q3. (page 214)

Why will a reduction in the real interest rate increase investment spending, other things equal?

Short Answer

Expert verified

A decline in the real interest rate means a decrease in the cost of investment. Thus, the investment spending increases due to lower costs.

Step by step solution

01

Meaning of investment demand

Investment demand is the demand for money/financial resources to fund the business activities like buying capital goods. The investment demand depends on the real interest rate, which is the cost of investment, and the expected profit rate, which is the investment return.

02

Inverse relationship between real interest rate and investment

As the real interest rate decreases, the cost of investment decreases. A lower cost encourages firms to demand more money for investment purposes and increase their production level. This would raise their expected return on investment. A higher expected rate of return stimulates the investment demand in the economy.

The investment demand is negatively sloped, as shown in the graph below:

When the real interest rate declines, the increasing investment is shown by the negatively sloped investment demand curve, ID0. Therefore, a decrease in the real interest rate increases investment spending, ceteris paribus.

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Most popular questions from this chapter

Suppose that disposable income, consumption, and saving in some country are \(200 billion, \)150 billion, and \(50 billion, respectively. Next, assume that disposable income increases by \)20 billion, consumption rises by \(18 billion, and saving goes up by \)2 billion. What is the economy鈥檚 MPC? Its MPS? What was the APC before the increase in disposable income? After the increase?

Suppose that the linear equation for consumption in a hypothetical economy is C = 40 + 0.8Y. Also, suppose that income (Y) is $400. Determine

  1. the marginal propensity to consume,

  2. the marginal propensity to save,

  3. the level of consumption,

  4. the average propensity to consume,

  5. the level of saving, and

  6. the average propensity to save.

Refer to the table in Figure 10.5 and suppose that the real interest rate is 6 percent. Next, assume that some factor changes such that the expected rate of return declines by 2 percentage points at each prospective level of investment. Assuming no change in the real interest rate, by how much and in what direction will investment change? Which of the following might cause this change: (a) a decision to increase inventories; (b) an increase in excess production capacity?

Suppose that an initial \(10 billion increase in investment spending expands GDP by \)10 billion in the first round of the multiplier process. If GDP and consumption both rise by \(6 billion in the second round of the process, what is the MPC in this economy? What is the size of the multiplier? If, instead, GDP and consumption both rose by \)8 billion in the second round, what would have been the size of the multiplier?

In year 1, Adam earns \(1,000 and saves \)100. In year 2, Adam gets a \(500 raise so that he earns a total of \)1,500. Out of that \(1,500, he saves \)200. What is Adam鈥檚 MPC out of his $500 raise?

  1. 0.50

  2. 0.75

  3. 0.80

  4. 1.00
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