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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

Why does a downshift of the consumption schedule typically involve an equal upshift of the saving schedule? What is the exception to this relationship?

If a \(50 billion initial increase in spending leads to a \)250 billion change in real GDP, how big is the multiplier?

  1. 1.0

  2. 2.5

  3. 4.0

  4. 5.0

In what direction will each of the following occurrences shift the consumption and saving schedules, other things equal?

  1. A large decrease in real estate values, including private homes.
  2. A sharp, sustained increase in stock prices.
  3. A 5-year increase in the minimum age for collecting Social Security benefits.
  4. An economywide expectation that a recession is over and that a robust expansion will occur.
  5. A substantial increase in household borrowing to finance auto purchases.

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?

Refer to the table below.

  1. Fill in the missing numbers in the table.

  2. What is the breakeven level of income in the table? What is the term that economists use for the saving situation shown at the $240 level of income?

  3. For each of the following items, indicate whether the value in the table is either constant or variable as income changes: the MPS, the APC, the MPC, the APS.
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