Lecture 5: Saving and Investment
What is the shape of the Investment demand curve? – Downward sloping. • Why? – When interest rates are high, fewer investments are profitable; when interest. Learning Objectives. Draw a hypothetical investment demand curve, and explain what it shows about the relationship between investment and the interest rate. Summarize relationships shown by the consumption schedule, the saving schedule, the investment demand curve, and the multiplier effect. Which of these What are the basic determinants of the consumption and saving schedules? Of your.
Remember from our lesson on National Income Accounting that investment only occurs when real capital is created. Investment is such an important part of our economy because it affects both short-run aggregate demand and long-run economic growth. The dollars spent on the investment have the immediate impact of increasing spending in the current time period.
But because of the nature of investment, it has a long-term impact on the economy as well. If a company buys a new machine, that machine is going to operate, continue to produce, and will have an impact on the productive capacity of the economy for years to come.
This is in contrast to consumption purchases that do not have the same impact. If you buy and eat an apple today, that apple does not continue to provide consumption benefits into the future.
Before the investment takes place, firms only know their expected rate of return. Therefore, investment almost always involves some risk. Consider the following scenario. You know that your equipment is slow and outdated. You also know that investing in modern computerized printing presses will yield a positive return for your business, but that they will be very expensive.
In order to undertake the investment in new equipment, you will have to borrow the money. Should you borrow the money and buy the new equipment? What will influence you decision? The key variable that will help you to decide whether the investment makes sense for you is the real interest rate that you will have to pay on the loan. If the expected rate of return in greater than the real interest rate, the investment makes sense.
If it is not, then the investment will not be profitable. The real interest rate determines the level of investment, even if you do not have to borrow the money to buy the equipment. The Investment Demand Curve As was illustrated in the example above, the real rate of interest has an impact on determining which investments can be undertaken profitably and which cannot.
Next, the focus is on the consumption-income and saving-income relationships which are part of the model. Third, investment is examined, and finally, the consumption, saving, and investment concepts are combined to explain the equilibrium levels of output, income, and employment in a private no governmentdomestic no foreign sector economy.
The "expected rate of net profit" has been changed to the "expected rate of return" which is the usual way economists express this idea. This terminology is consistent with the presentation on Research and Development in the new Chapter The investment-demand curve is now a Key Graph with Quick Quiz and the discussion surrounding it has been rewritten for clarity.
There is a new Figure which shows the shifts in the investment-demand curve. The discussion of the "stock capital on hand" has been revised and included as a determinant of investment. A new Figure a and b show the "connection" between the real interest rate, the investment-demand curve and the economy's investment schedule.
A change in a variable held constant in drawing this curve shifts the curve. One of those variables is the cost of capital goods themselves. If, for example, the construction cost of new buildings rises, then the quantity of investment at any interest rate is likely to fall.
The investment demand curve thus shifts to the left.
Lecture 5: Saving and Investment
Other Factor Costs Firms have a range of choices concerning how particular goods can be produced. A factory, for example, might use a sophisticated capital facility and relatively few workers, or it might use more workers and relatively less capital.
The choice to use capital will be affected by the cost of the capital goods and the interest rate, but it will also be affected by the cost of labor.Investment and real interest rates - Macroeconomics - Khan Academy
As labor costs rise, the demand for capital is likely to increase. Our solar energy collector example suggests that energy costs influence the demand for capital as well. If these prices were higher, the savings from the solar energy system would be greater, increasing the demand for this form of capital.
Technological Change The implementation of new technology often requires new capital. Changes in technology can thus increase the demand for capital. Advances in computer technology have encouraged massive investments in computers. The development of fiber-optic technology for transmitting signals has stimulated huge investments by telephone and cable television companies.
Determinants of Investment
Public Policy Public policy can have significant effects on the demand for capital. Such policies typically seek to affect the cost of capital to firms.
The Kennedy administration introduced two such strategies in the early s. One strategy, accelerated depreciation, allowed firms to depreciate capital assets over a very short period of time.
The second strategy was the investment tax credit, which permitted a firm to reduce its tax liability by a percentage of its investment during a period. Though less direct, a third strategy for stimulating investment would be a reduction in taxes on corporate profits called the corporate income tax. Greater after-tax profits mean that firms can retain a greater portion of any return on an investment. A fourth measure to encourage greater capital accumulation is a capital gains tax rate that allows gains on assets held during a certain period to be taxed at a different rate than other income.
When an asset such as a building is sold for more than its purchase price, the seller of the asset is said to have realized a capital gain. Such a gain could be taxed as income under the personal income tax. Alternatively, it could be taxed at a lower rate reserved exclusively for such gains. A lower capital gains tax rate makes assets subject to the tax more attractive. It thus increases the demand for capital. A proposal to eliminate capital gains taxation for smaller firms was considered but dropped before the stimulus bill of was enacted.
Accelerated depreciation, the investment tax credit, and lower taxes on corporate profits and capital gains all increase the demand for private physical capital. Public policy can also affect the demands for other forms of capital.
The federal government subsidizes state and local government production of transportation, education, and many other facilities to encourage greater investment in public sector capital. Key Takeaways The quantity of investment demanded in any period is negatively related to the interest rate. This relationship is illustrated by the investment demand curve. A change in the interest rate causes a movement along the investment demand curve.
A change in any other determinant of investment causes a shift of the curve.
The other determinants of investment include expectations, the level of economic activity, the stock of capital, the capacity utilization rate, the cost of capital goods, other factor costs, technological change, and public policy.
Show how the investment demand curve would be affected by each of the following: A sharp increase in taxes on profits earned by firms An increase in the minimum wage The expectation that there will be a sharp upsurge in the level of economic activity An increase in the cost of new capital goods An increase in interest rates An increase in the level of economic activity A natural disaster that destroys a significant fraction of the capital stock Case in Point: To try to spur growth, Congress, supported by President Bush, passed a law in called the American Jobs Creation Act that gave businesses a one-year special tax break on any profits accumulating overseas that were transferred to the United States.
Did the tax break have the desired effect on the economy?