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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

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 a handbill publisher can buy a new duplicating machine for \(500, and the duplicator has a 1-year life. The machine is expected to contribute \)550 to the year's net revenue. What is the expected rate of return? If the real interest rate at which funds can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the machine? Will it invest in the machine if the real interest rate is 9 percent? If it is 11 percent?

Why is investment spending unstable?

Irving owns a chain of movie theaters. He is considering whether he should build a new theater downtown. The expected rate of return is 15 percent per year. He can borrow money at a 12 percent interest rate to finance the project. Should Irving proceed with this project?

  1. Yes

  2. No

In what direction will each of the following occurrences shift the investment demand curve, other things equal?

  1. An increase in unused production capacity occurs.

  2. Business taxes decline.

  3. The cost of acquiring equipment falls.

  4. Widespread pessimism arises about future business conditions and sales revenues.

  5. A major new technological breakthrough creates prospects for a wide range of profitable new products.
See all solutions

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