Unit III

Interest Rates & Investment 

Investment: money spent or expenditures on 

- new plants(factories) 

- capital equipment (machinery)

- technology (hardware and software)

- new homes

- inventories (sold by producers)

Expected Rates of return: 

•How does businesses make investment decisions?  

Cost/ benefit analysis 

•How does business determine the benefits? 

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 return > interest cost, then invest

• if expected return < interest, then do not invest 

Real vs Nominal 

Nominal is the observable rate of interest. Real subtracts out inflation and is only know. Ex post facto. 

How do you compute the real interest rate (£%) 

r%=i%-£%

R=real interest rate 

I= nominal interest rate 

£=inflation 

What then determines the cost of an investment decision?

The real interest rate (r%)

Investment Demand Curve:(ID): What is the shape of the investment demand curve? 

Downward sloping

- because when the interest rates are high fewer investments are profitable when interest rates are low, more investments are profitable. 

Shifts in Investment Demands (ID): cost of production: lower costs shift ID to the right 

Higher costs shift ID to the left 

Business Taxes: lower business taxes shifts ID to the right 

Higher business taxes shifts ID to the left 

Technological Change: 

New technology shifts ID to the right 

Lack of technological change shifts ID to the left 

Stick of capital: 

If an economy is low on capital then ID shifts to the right

If an economy has much capital then ID shifts to the left

Expectations: 

Positive expectations, ID shifts to the right

Negative expectations, ID shifts to the left 

Long run AS is a vertical line at an out put level, that represents the quantity of goods and services a nation can produce over a sustain period using all of its productive resources as efficiently as possible with all of the current technology available to it. 

Is stable at full employment 

LRAS curve represents a point on an economy's production possibilities curve. 

LRAS is synonymous got pf to shift outward 

Does not change as the price level changes 

Consumption: household spending, the ability to consume is constrained by - the amount of disposable income and the propensity to save. 

Do households consume if DI=0? 

-Autonomous consumption 

-Dissaving

APC=C/DI=% DI that is spent. Saving: household NOT spending 

The ability to save is constrained by- the amount of disposable income and the propensity to consume. Do households save if DI=0? No 

APS=S/DI=%DI that is not spent. 

Disposable Income: Income after taxes orbit Income 

DI= Gross Income-Taxes 

With disposable income, households can either: 

- Consume (spend money on goods and services)  

- Save (not spend money on goods and services) 

 

APC and APS

APC+APS=1

1-APC=APS

1-APS=APC

APC > Dissaving

-APS Dissaving 

MPC and MPS:

MPC: marginal Propensity to consume: change in c/ change in DI

% of every extra dollar earned that is spent 

Marginal Propensity to Save: change in s/ change in DI

% of every extra dollar earned that is saved 

MPC+MPS=1 

1-MPC=MPS

1-MPS=MPC 

The Spending Multiplier Effect: an initial change in spending (C,Xn,Ig,G) causes a larger change in aggregate spending or aggregate demand 

Multiplier= change in AD/ change in spending 

Why did this happen? Expenditures and income flow continuously which sets off a spending increase in the economy. 

Calculations the spending Multiplier: the spending multiplier can be calculated from the MPC or the MPS. Multiplier= 1/1-MPC or 1/MPS 

Multipliers are + when there is an increase in spending and - when there is a decrease. 

Calculating the Tax Multiplier: when he government taxes, the multiplier works in reverse. Why? Because now money is leaving the circular flow. Tax Multiplier (note: it's negative) = -MPC/1-MPC OR -MPC/MPS 

If there is a tax CUT then the multiplier is positive because there is now more money in the circular flow. 

Fiscal Policy: 

Changes in the expenditures or tax revenues of the federal government: 2 tools of fiscal policy: taxes: government can increase or decrease taxes. 

Spending: government can increase or decrease spending. 

Deficits, Surpluses, and Debt; 

Balanced budget: revenues = expenditures 

Budget Deficit: revenues < expenditures 

Budget Surplus: revenues > expenditures 

Government Debt: Sum of all deficits 

Government must borrow money when it runs a budget deficit.

Government borrows from individuals, corporations, financial institutions, foreign entitlement of foreign government. 

Fiscal Policy: discretionary Fiscal Policy:(action): Expansionary fiscal policy-think deficit 

Contractionary fiscal policy- think surplus 

Non-Discretionary Fiscal policy: no action. 

Discretionary v. Automatic Fiscal Policies: 

Discretionary: increasing or decreasing Government spending and or taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.  

Automatic: unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems. 

Contractionary vs. Expansionary Fiscal policy:

Contractionary fiscal policy: policy designed to decrease aggregate demand. - strategy for controlling inflation. Inflation is contested with Contractionary policy. Decrease government spending. 

Expansionary Fiscal Policy: policy designed to increase aggregate demand. Strategy for increasing GDP, combatting a recession and reducing unemployment. 

Recession is countered with Expansionary policy. increase government spending. Decrease taxes. 

Automatic or Built in Stabilizers: anything that increases the governments budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers.  

Transfer Payments: welfare checks, food stamps, unemployment checks, corporate dividends, social security, veterans benefits. 

Progressive Tax System: average tax rate(tax revenue/GDP) rises with GDP. 

Proportional Tax System; average tax rate remains constant as GDP changes.

Regressive Tax System: average tax rate falls with GDP