Gross Domestic Gross Domestic InvestmentsInvestments

o45

o

CC

370 390390 410 430 450 470470 490 510 530 550

$530

510

490

470470

450

430

410

390

370

Yesterday we looked at the consumption function model, which is simply the aggregate expenditure model using consumption (in CIGX) only.

Consumption

Disposable income

(C = DI)

o45

o

CC

C + IC + Igg

IIg g = $20 Billion= $20 Billion

370 390390 410 430 450 470470 490 510 530 550

C =$450 BillionC =$450 Billion

$530

510

490

470470

450

430

410

390

370

Real GDPReal GDP

Now let’s add gross domestic investments to the topic and see how it will affect aggregate expenditures.

• Gross Domestic Investments (Ig) – the expenditures on new capital goods for future production.

• Businesses will invest in new capital goods if the investment project(s) is profitable for the company.

• Marginal benefits = the expected rate of return (profit) a business expects from its investment.

• Marginal cost = the expected cost of making the investment. (purchase cost + interest rates).

• Businesses will invest if MB >or = MC.

Investment:Investment:

Let’s say we have a company that generates a yearly profit of $100,000. We want to invest in a new drill press that will cost the company $9,000, and it will have a life of only one year.

The company expects that the new drill press will increase the company’s productivity by 10%.

Marginal cost = $9,000

Marginal benefit = $10,000(10% increase of $100,000)

Yes, the company undertakes the investment opportunity.

But what if the company has to borrow the money from a bank in order to make the investment. In that case the interest paid on the borrow loan is also part of the marginal cost of the investment. Since interest rates are the cost of borrowing money.

IR = Marginal cost of Ig.

Let’s say that an investment loan of $9,000 will carry a 12% interest fee. The interest on the loan will increase the marginal cost of this investment by $1080.

(9,000 x .12 = 1,080)Making the total marginal cost $10,080.

($9,000 + 1,080 = $10,080)

Should the Equipment be

purchased?

It appears that the company will not make the investment.

NominalNominalInterestInterest

RateRate

RealRealInterestInterest

RateRate

AnticipatedAnticipatedInflationInflation

--

1212%% 99%%

33%%==

But, if you remember back to the lesson inflation, the affects of inflation helps borrowers. Borrowers pay back money that has less value. It is the real interest rate (RIR) that is true cost of borrowing money.

If the real interest rate (RIR) is the 9%, then the marginal cost of this investment has only increased $810. Making the total Marginal cost $9,810.

(9,000 + 810 = $9,810)

Should the Equipment be

purchased?

It appears that the company will make the investment; because the marginal benefit is still $10,000.

Lowering interest rates make the marginal benefits Of capital investments more profitable for businesses. This will increase the demand for money to make gross domestic investments. As RIR decreases the demand for Ig will increase.

There is an inverse relationship between (rir) and Qm There is an inverse relationship between (rir) and Qm

We can illustrate this inverse relationship between real interest rates and the quantity of money by using an “investment demand model”.

RIR16

14

12

10

88%%

6

44%%

2

05 10 15 2020 25 3030 35 40 QMQM QMQM

DIg

Qm

Investment Demand Model

RIR16

14

12

10

88%%

6

44%%

2

05 10 15 2020 25 3030 35 40 QMQM QMQM

DIg

The quantity of money demanded for investments increases as interest rates decrease. This is illustrated as a movement from point (A) to point (B) on a fixed investment demand curve. Businesses borrow more quantity of money because it is cheaper to do so.

A

B

Qm

QQmm100100 200200

25%25%

2020%%

15%15%

10%10%

5%5%

00 5050 150150 250250

But sometimes the entire demand curve can shift and change the entire demand for Ig. Such changes occur without any change in interest rates. One of five non-interest rate factors

(determinants) has caused this change. Known as tastetaste.

RIR

DIg1DIg2

Non-interest rate determinants;Non-interest rate determinants;

• TechnologyTechnology; the development of new technology shifts the investment demand curve to the right, as businesses upgrade.

• Acquisition of operation costAcquisition of operation cost; when production cost fall, expected rates of return from prospective investments rise shifting the demand curve to the right.

• Stock of inventoryStock of inventory; businesses with dwindling inventories will invest in expansion, thus shifting the demand curve right.

• TaxesTaxes; lower business taxes increases the expected profitability of investments, and shift the demand curve right.

• ExpectationExpectation; optimism about future profits increase investments and shift the demand curve right.

VolVolatility of Investmenttility of Investment

R R R R R R R R R R R R R R

Investments are very volatile (hard to predict). Just because interest rates are lowered does not mean that businesses will increase their investments of capital goods. The reason is because of DIEDIE!!

•Durability of CapitalDurability of Capital; ; some some

machines are more durable than machines are more durable than

other. other. The more durable them The more durable them

capital the less need for capital the less need for

replacing itreplacing it..

Reasons for Investment VolatilityReasons for Investment Volatility

•Irregularity of innovationsIrregularity of innovations; ;

its hard to predict when the its hard to predict when the

next new invention will next new invention will

occuroccur..

•Expectations; Expectations; pessimism about pessimism about

future profits will cause firms to future profits will cause firms to

keep older equipment and avoid keep older equipment and avoid

investmentinvestment..