UNIT 3: Interest rates and Interest Demand

                                                Interest Rates and Interest Demand

  What is investment?

·         Money spent or expenditures on:

-          New exports (factories)

-          Capital equipment (machinery)

-          Technology (hardware and software)

-          New homes

-          Inventories (goods sold by producers)

Expected rates of return

·         How does a business make investment decisions?

-          Cost/benefit analysis

·         How does business determine the benefits?

-          Expected rate of return.

·         How does business count the cost?

-          Interest costs.

·         How does business determine the amount of investment they undertake?

-          Compare expected rate of return to interest cost.

·         If expected return >interest cost, then invest

·         If expected return < interest cost, then do not invest.

                                              Real (r%) v. nominal (i%)

-          Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto.

-          How do you compute the real interest rate (r%) ?

               r% = i% - π% (π means inflation)

-          What then, determines the cost of an investment decision?

·         The real interest rate (r%)

        Investment demand curve (ID)

ØWhat is the shape of the investment curve?

-          Downward sloping.

Ø  Why?

-          When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

                        Shifts in investment demand (ID)

·         Cost of production

-          Lower cost shifts ID to the right.

-          Higher costs shifts ID to the left.

·         Business Taxes

-          Lower business taxes shifts ID to the right

-          Higher business taxes shifts ID to the left

Technological change

-          New technology shifts ID to the right.

-          Lack of technological change shifts ID to the left.

Stock of capital

-          If economy is low on capital, then ID shifts to the right.

-          If an economy has much capital, then ID shifts to the left.

Expectations

-          Positive expectations shifts ID to the right

-          Negative expectations shifts ID to the left

                      Difference between classical and Keynesian

                                                   Classical

·         Competition is good.

·         The invisible hand (means market will fix itself no government needed).

·         In the long run the economy will balance at full employment

·         Trickledown effect (help the rich first and everybody else second).

·         The economy is always close to or at full employment.

                        

                                          Keynesian

·         Competition is fraud.

·         AD is the key not AS.

·         Lits and savings cause recessions.

·         Ratchets effects and sticky wages blocked says law.

·         In the long run we are all dead.