3.

3 HW
3.3 – Investment Demand and the AD/SRAS Model
Due: Tues. 2/20 (GOLD) ** Wed. 2/21 (BLUE)
Directions: Use the information from lecture, the reference information below, and the reading and questions from
homework 2.1 to help you complete the following questions.
Investment Demand – Reference Information
Investment (Ig) is a component of GDP and changes in Ig cause shifts of Aggregate Demand (AD). An increase in Ig
will cause an increase in AD. A decrease in Ig will cause a decrease in Ig.

Expected rate of return = (Expected additional revenue resulting from the investment-Cost of the investment)/Cost
of the investment
Real interest rate – “the price of borrowed money.” The rate charged for borrowed money that may be used to
invest

What determines Investment Demand?

Individual firms engage in marginal analysis to determine whether to invest (purchase capital). The marginal benefit
of investing is the expected rate of return on the investment. The marginal cost of investing is the real interest rate
charged for the borrowed money used to purchase the capital (or the opportunity cost of the forgone interest that
could be earned on funds used by a company to purchase capital). If expected rate of return is equal to or greater
than the real interest rate, firms will choose to invest. At higher real interest rates, the quantity of investment
demanded will be lower. At lower real interest rates, the quantity of investment demanded will be higher. Note that
this follows the law of demand you learned in Unit 1. Investment demand is a micro-supply and demand curve. See
the graph below.

rir

ID

Investment Spending

Movement along the curve.

Quantity invested declines as interest rates increase. Quantity invested increases as interest rates decrease.

Shifts of the curve – non-interest rate determinants in response to expected returns.

 Cost of capital goods (initial and operating) – if costs increase, ID will decrease
 Business taxes – if taxes increase, ID will decrease
 Technology – if technology improves, ID will increase
 Expectations of future sales, costs, and profits – if firms expect future sales and profits to increase, they will
invest more at every given price (ID will increase)
 Excess capacity – if firms have a lot of excess capacity (capital that is not in use, but may be employed if
production expands), they will be less likely to purchase new capital (ID will decrease)
Investment is the most volatile component of AD. Why?
 Purchase of capital goods can be postponed.
 Innovations are irregular (sometimes people invent new things)
 Current profits, which influence future investments, are variable
 Expectations are highly variable – ex. Business climate (political changes), stock market volatility

Changes in investment cause most of the fluctuations in output (GDP) and employment
 3.3 HW
1. Imagine you own a computer factory. You want to buy a new machine to improve production of your
hard drives and it costs $2000. You expect that this new machine will last for one year and return an
added revenue of $2200. What is your expected rate of return? If the current real interest rate is 6%,
should you invest (purchase the new machine)?

2. If the real interest rate increases, what will happen to the quantity of Investment Demanded? Draw
an investment demand curve and show this occurring. As a result of this change, what will happen to
aggregate demand?

3. Draw an investment demand curve. Show what will happen if the government increases business
taxes? What impact will this have on aggregate demand?

4. Explain why investment is the most volatile component of AD.

5. Draw a correctly labeled Aggregate Supply and Demand curve. Show what will happen if the
Government increases its spending. Write what happens to output (GDP). What happens to
unemployment? What happens to price level/inflation?

6. Draw a correctly labeled aggregate supply and demand curve. Show what will happen if the stock
market crashes (decrease in consumer wealth). What happens to output (GDP)? Unemployment?
Price level/Inflation?