- Draw a hypothetical investment demand curve, and explain what it shows about the relationship between investment and the interest rate.
- Discuss the factors that can cause an investment demand curve to shift.
We will see in this section that interest rates play a key role in the determination of the desired stock of capital and thus of investment. Because investment is a process through which capital is increased in one period for use in future periods, expectations play an important role in investment as well.
Capital is one factor of production, along with labor and natural resources. A decision to invest is a decision to use more capital in producing goods and services. Factors that affect firms’ choices in the mix of capital, labor, and natural resources will affect investment as well.
We will also see in this section that public policy affects investment. Some investment is done by government agencies as they add to the public stock of capital. In addition, the tax and regulatory policies chosen by the public sector can affect the investment choices of private firms and individuals.
Interest Rates and Investment
We often hear reports that low interest rates have stimulated housing construction or that high rates have reduced it. Such reports imply a negative relationship between interest rates and investment in residential structures. This relationship applies to all forms of investment: higher interest rates tend to reduce the quantity of investment, while lower interest rates increase it.
To see the relationship between interest rates and investment, suppose you own a small factory and are considering the installation of a solar energy collection system to heat your building. You have determined that the cost of installing the system would be $10,000 and that the system would lower your energy bills by $1,000 per year. To simplify the example, we shall suppose that these savings will continue forever and that the system will never need repair or maintenance. Thus, we need to consider only the $10,000 purchase price and the $1,000 annual savings.
If the system is installed, it will be an addition to the capital stock and will therefore be counted as investment. Should you purchase the system?
Suppose that your business already has the $10,000 on hand. You are considering whether to use the money for the solar energy system or for the purchase of a bond. Your decision to purchase the system or the bond will depend on the interest rate you could earn on the bond.
Putting $10,000 into the solar energy system generates an effective income of $1,000 per year—the saving the system will produce. That is a return of 10% per year. Suppose the bond yields a 12% annual interest. It thus generates interest income of $1,200 per year, enough to pay the $1,000 in heating bills and have $200 left over. At an interest rate of 12%, the bond is the better purchase. If, however, the interest rate on bonds were 8%, then the solar energy system would yield a higher income than the bond. At interest rates below 10%, you will invest in the solar energy system. At interest rates above 10%, you will buy a bond instead. At an interest rate of precisely 10%, it is a toss-up.
If you do not have the $10,000 on hand and would need to borrow the money to purchase the solar energy system, the interest rate still governs your decision. At interest rates below 10%, it makes sense to borrow the money and invest in the system. At interest rates above 10%, it does not.
In effect, the interest rate represents the opportunity cost of putting funds into the solar energy system rather than into a bond. The cost of putting the $10,000 into the system is the interest you would forgo by not purchasing the bond.
At any one time, millions of investment choices hinge on the interest rate. Each decision to invest will make sense at some interest rates but not at others. The higher the interest rate, the fewer potential investments will be justified; the lower the interest rate, the greater the number that will be justified. There is thus a negative relationship between the interest rate and the level of investment.
Figure 14.5 “The Investment Demand Curve” shows an investment demand curve for the economy—a curve that shows the quantity of investment demanded at each interest rate, with all other determinants of investment unchanged. At an interest rate of 8%, the level of investment is $950 billion per year at point A. At a lower interest rate of 6%, the investment demand curve shows that the quantity of investment demanded will rise to $1,000 billion per year at point B. A reduction in the interest rate thus causes a movement along the investment demand curve.
To make sense of the relationship between interest rates and investment, you must remember that investment is an addition to capital, and that capital is something that has been produced in order to produce other goods and services. A bond is not capital. The purchase of a bond is not an investment. We can thus think of purchasing bonds as a financial investment—that is, as an alternative to investment. The more attractive bonds are (i.e., the higher their interest rate), the less attractive investment becomes. If we forget that investment is an addition to the capital stock and that the purchase of a bond is not investment, we can fall into the following kind of error: “Higher interest rates mean a greater return on bonds, so more people will purchase them. Higher interest rates will therefore lead to greater investment.” That is a mistake, of course, because the purchase of a bond is not an investment. Higher interest rates increase the opportunity cost of using funds for investment. They reduce investment.