16:Investment, Capital,and Interest

Overview How are business investment

decisions made? How are household saving decisions

made? How do investment, saving, and

consumption interact to determine the real interest rate?

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Capital and Interest The capital stock is the quantity of plant,

equipment, buildings, and inventories. Gross investment is the purchase of

new plant, equipment, and buildings, as well as additions to inventories.

Depreciation is the amount of the capital stock that is worn out each year.

Net= Gross - Depreciation

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fig. 9.1 page 192

Government Investment

Investment as measured in the GDP accounts includes only private business investment.

The part of government purchases that creates social infrastructure should be counted as investment.

Social infrastructure includes highways, schools, and dams.

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Interest Rates The return on capital is the real

interest rate. The real interest rate is equal to the

interest rate on a loan minus the inflation rate.

The interest rate on a loan must be greater than the inflation rate so the lender’s purchasing power will increase from making the loan.

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Inflation and Interest Rates An interest rate is the amount received by

a lender and paid by a borrower expressed as a percentage amount of the loan.

Higher inflation rates usually cause higher interest rates because lenders want to be compensated for the decrease in the purchasing power of money.

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From a Market Perspective, view this as.

P

Credit

int rate Hence inflputs upward pressure on rates.

S

D

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From a Market Perspective, view this as.

P

Credit

int rate Hence inflputs upward pressure on rates.

D

S

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The Value of Money A rise in the average price level causes

money to lose its purchasing power. The purchasing power of money (also called

the value of money) is the amount of goods and services that can be bought with a given sum of money.

The rate at which money loses its value is equal to the inflation rate.

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The Real Interest Rate The nominal interest rate is the interest

rate calculated in money terms. When the value of money is falling, we

must use the real interest rate to determine the net increase in purchasing power a lender receives.

The real interest rate equals the nominal interest rate minus the inflation rate.

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remember nominal = real + infla

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Figure 9.3 page 194

Investment Decisions

The main influences on business investment decisions are: The expected future profit rate The real interest rate

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Investment Demand Investment demand is the

relationship between the level of planned investment and the real interest rate, all other influences on investment remaining the same. The investment demand schedule lists

planned investment at each real interest rate.

The investment demand curve graphs this relationship.

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Figure 9.4 page 196

Saving andConsumption Decisions

A nation’s investment is financed by its national saving and by its borrowing from the rest of the world.

National saving is the sum of private saving and government saving. The amount a nation saves is

determined by decisions of households and government fiscal policy.

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Income, Consumption,and Saving

Households receive disposable income (earned income plus transfer payments minus taxes).

They must decide how to allocate that income between saving and consumption expenditure.

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The Household’s Decision

The most important factors influencing household saving and consumption decisions are: Real interest rate Disposable income

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Saving Supply

Saving (trillions of 1992 dollars)

SS0

Rea

l int

eres

t ra

te (

perc

ent

per

year

)

4

6

8

10

12

0 0.8 0.9 1.0 1.1 1.2 1.3

A increasein saving supply

2

SS1

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Saving Supply

Saving (trillions of 1992 dollars)

SS0

Rea

l int

eres

t ra

te (

perc

ent

per

year

)

4

6

8

10

12

0 0.8 0.9 1.0 1.1 1.2 1.3

A increasein saving supply

A decreasein saving supply

2

SS1

SS2

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Figure 8.9 page 190

Long-Run Equilibriumin the Global Economy

Investment decisions interact with consumption and saving decisions to determine the real interest rate.

The real interest rate is determined in the global capital market because there is no way to restrict the international flow of capital.

Capital flows toward high returns. MACRO HAPPENS

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Determining the Real Interest Rate: S=I

Equilibrium between world investment demand and world saving supply determines the real interest rate.

To see this simply combine the investment schedule we derived earlier with the savings schedule above to obtain

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mkt for savings and investment Fig 9.8 page 201

Explaining Changes inthe Real Interest Rate

The real interest rate changes: In 1995, the real interest rate was very

high at 6% a year. In 1984, the real interest rate was 8.5%. In 1975, the real interest rate was -1%.

Why has the real interest rate changed over time?

What has happened since 1995??? MACRO HAPPENS

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