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How is it possible for investment spending to increase even in a period in which the real interest rate rises?
Wiki User
∙ 11y ago
The basic determinants of investment are the expected rate of return (net profit) that businesses hope to realize from investment spending, and the real rate of interest.
When the real interest rate rises, investment decreases; and when the real interest rate drops, investment increases—other things equal in both cases. The reason for this relationship is that it makes sense to borrow money at, say, 10 percent, if the expected rate of net profit is higher than 10 percent, for then one makes a profit on the borrowed money. But if the expected rate of net profit is less than 10 percent, borrowing the money would be expected to result in a negative rate of return on the borrowed money. Even if the firm has money of its own to invest, the principle still holds: The firm would not be maximizing profit if it used its own money to carry out an investment returning, say, 9 percent when it could lend the money at an interest rate of 10 percent.
Investment is unstable because, unlike most consumption, it can be put off. In good times, with demand strong and rising, businesses will bring in more machines and replace old ones. In times of economic downturn, no new machines will be ordered. A firm can continue for years with, say, a tenth of the investment it was carrying out in the boom. Very few families could cut their consumption so drastically.
New business ideas and the innovations that spring from them do not come at a constant rate. This is another reason for the irregularity of investment. Profits and the expectations of profits also vary. Since profits, in the absence of easy access to borrowed money, are essential for investment and since, moreover, the object of investment is to make a profit, investment, too, must vary.
As long as expected rates of return rise faster than real interest rates, investment spending may increase. This is most likely to occur during periods of economic expansion.
Wiki User
∙ 11y ago
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How does the global financial crisis effect nz?
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What did Kennedy increase in order to build up the nations conventional forces?
Flexible Response.
The term bomber gap was used during the cold war for the primary purpose of?
Greatly increase military spending
When In 1998 the Japanese Parliament passed a series of bills which called for to help the economy recover.?
the government to increase spending
What was the pump priming during Roosevelt?
Using government spending to increase purchasing power and stimulate the economy during the Great Depression.
What is the most likely result of an increase in interest rates a. investment spending rises b. investment spending falls c. the economy speeds up d. unemployment falls?
b. investment spending falls
What is the crowding out?
A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect
What is the crowding-out effect?
A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect
Which is most likely to be affected by changes in the rate of interest?
investment spending
What does crowding out mean?
Increased government spending results in higher interest rates which puts downward pressure on investment spending.
Can anyone helps to explain the links between changes in the nations money supply the interest rate investment spending aggregate demand and real GDP and the price level?
An increase in the nation's money supply lowers interest rates, thus decreases the cost of doing business. With a higher return on investment, investment spending increases and so too does aggregate supply. As aggregate supply increases, aggregate demand increases and so prices go up. Thus real GDP and APL increase.
A change is the money supply will change investment when?
Monetary policy will never be effective if interest rates: not respond to a change in the money supply, and investment spending does not respond to changes in the interest rate.
An increase in government spending with no change in taxes leads to a?
higher interest rate
What happens to consumer and businesses spending when the interest rates go up?
They both increase
What is one possible short-term effect of an easy money policy?
increased investment spending
What is crowding costs?
In economics, crowding out is a phenomenon occurring when Expansionary Fiscal Policy causes interest rates to rise, thereby reducing investment spending. That means increase in government spending crowds out investment spending.Changes in fiscal policy shifts the IS curve, the curve which describes equilibrium in the goods market. A Fiscal Expansion shifts IS curve to the right from IS1 to IS2. A fiscal expansion increases equilibrium income from Y1 to Y2 and interest rates from i1 to i2. At unchanged interest rates i1, the higher level of government spending increase the level of Aggregate Demand. This increase in demand must be met by rise in output. At each level of interest rate, equilibrim income must rise by the multiplier times the increase in government spending.If the interest rate stayed constant at i1, the goods market is in equilibrium in that planned spending equals output, but the assets market is no longer in equilibrium. Income has increased, and, therefore, the quantity of money demanded is higher. Because there is an excessive demand for real balances, the interest rate rises. Firms planned spending declines at higher interest rates, thus the aggregate demand falls. Therefore, the equilibrium is at higher interest rates. The adjustment of interest rates and their impact on aggregate demand dampen the expansionary effect of the increased government spending.Source: Wikipedia
What is crowding?
In economics, crowding out is a phenomenon occurring when Expansionary Fiscal Policy causes interest rates to rise, thereby reducing investment spending. That means increase in government spending crowds out investment spending.Changes in fiscal policy shifts the IS curve, the curve which describes equilibrium in the goods market. A Fiscal Expansion shifts IS curve to the right from IS1 to IS2. A fiscal expansion increases equilibrium income from Y1 to Y2 and interest rates from i1 to i2. At unchanged interest rates i1, the higher level of government spending increase the level of Aggregate Demand. This increase in demand must be met by rise in output. At each level of interest rate, equilibrim income must rise by the multiplier times the increase in government spending.If the interest rate stayed constant at i1, the goods market is in equilibrium in that planned spending equals output, but the assets market is no longer in equilibrium. Income has increased, and, therefore, the quantity of money demanded is higher. Because there is an excessive demand for real balances, the interest rate rises. Firms planned spending declines at higher interest rates, thus the aggregate demand falls. Therefore, the equilibrium is at higher interest rates. The adjustment of interest rates and their impact on aggregate demand dampen the expansionary effect of the increased government spending.Source: Wikipedia
