THE INVESTMENT DEMAND CURVE

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THE INVESTMENT DEMAND CURVE

In analyzing the determinants of investment, we focus particularly on the relationship between interest rates and investment, is crucial because interest rates (influenced by central banks) are the major instrument by which governments influence investment. To show the relationship between interest rates and investment. economists use a schedule called the demand.

Consider a simplified economy where firms can invest indifferent projects: A, B, C, and so forth, up to H These investments are so durable (like power plants or buildings) that we can ignore the need for replacement. Further, they yield a constant stream of net income each year, and there is no inflation. Table 22-5 shows the financial data on each of the investment projects.

Thus at a 10 percent annual interest rate, the’ cost of borrowing $1000 is $100 a year, as is shown in all entries of column (4); at a 5 percent interest rate, the borrowing cost, is $50 per $1000 borrowed per year.

Finally, the last two columns show the annual net profile from each investment. For lucrative project A. the net annual profit is $1400 a year Per $1000 invested at a 10 percent interest ‘rate. Project H loses money.

Look again at Table 22-5 and examine the last column, showing annual net profit at a 5 percent interest rate. Note that at this interest rate, investment projects A through G would be .profitable. We would thus expect profit-maximizing firms to invest in all seven projects. which [from column (2)] total up to $55 million in investment. Thus at a 5. percent interest rate, investment demand would be $55 million.

We show the results of this analysis in Figure 12-9. This figure shows the demandfor-inwstmmt scWule which is here a downward-sloping step function of the interest rate. This schedule shows the amount of investment that would be undertaken at each interest rate; it is obtained by adding up all the . investments that would be profitable at each level of the interest rate.

Hence, if the market interest rate is 5 percent, the desired level of investment will occur at point M, which shows investment of $55 million. At this interest rate, projects A through G are undertaken. If interest rates were to rise to 10 percent, projects F. and G would be squeezed out; in this situation, investment demand would lie at point M in Figure 22-9, with total investment of 30 million.5

THE INVESTMENT DEMAND CURVE

THE INVESTMENT DEMAND CURVE

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THE INVESTMENT DEMAND CURVE