Interest rates & Investment Demand & LRAS V SRAS (2/21/17)

Interest rates & Investment Demand

What is Investment

• Money spent on expenditures on:

- New plants (factories)

- Capital equipment (machinery)

- Technology (hardware &software)

- New homes

- Investment (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?

- Cost / Benefit Analysis

• How does business determine the benifits?

- Expected rate of return

• How does business count the cost?

- Interest costs

• How does business determine the amount of investment they undertake

- Compare expected rate of return to interest cost

- If expected rate of return > I.C., then invest

- If expected rate of return < I.C., then do not investment

Real (r%) v Nominal (i%)

• How do you compute the real interest rate ( r%)

r% = i% -  π% 

• What there determines the cost of an investment decision?

- The real interest rate (r%)

Investment Demand Curve (ID)

• What is the shape of the investment?

-Downward slopping

• Why?

When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

Shifts in Investment Demand

- Cost of Production

- Business taxes

- Stock of Capital

- expectations

Long-Run v. Short-Run

Long-Run Aggregate Supply (LRAS)

• The Long-Run aggregate supply marks the level of full employment in the economy (analogous to the PPC)

only thing that shifts will be the determinants

Y_f – full employment

Short-Run Aggregate Supply (SRAS)

• Because input prices are sticky in the shhort-run, the SRAS is upward slopping

Changes in SRAS

•  An increase in SRAS is seen as a shift to the right. SRAS ->
• A decrease in SRAS is seen as a shift to the left. SRAS <-
•  The key to understanding shift in SRAS is per unit cost of production.

 Per unit cost of production cost = total input cost/total output

Changes in SRAS

(increases/ decreases) 

Determinants of SRAS

• Input Prices
• Productivity
• legal Institutional Environment

Input Prices

• Domestic Resource Prices

- Wages (75% of all business costs)

- Cost of capital

- Raw materials (commodity prices)

• Market Power

- Monopolies and cartels that control resources control the price of those resources

 Increase in Resource Prices = SRAS <-

 Decrease in Resource Prices = SRAS ->

Productivity

• Productivity = total output / total  input
• More productivity =  lower unit production cost = SRAS ->
• Less productivity =  higher unit production cost = SRAS <-

Legal Institutional Environment

• Taxes and Subsidies

- Taxes ($ to gov't) on business increase per unit of production cost = SRAS <-

- Subsidies ($ from gov't) to  business reduce per unit of production cost = SRAS ->

• Government Regulation

- Government regulation creates a cost of compliance = SRAS <-

- Deregulation reduces compliance costs = SRAS ->