Investment Demand Curve

A profit-maximizing firm will undertake any investment project that adds to its profits. Under what conditions will a particular investment be profitable? By comparing the additional sales revenue generated by the project over time to the project's anticipated costs, we can find the project's expected rate of return, r. The investment project will be profitable if this expected real rate of return opportunity cost of the funds - the real interest rate, i—used to finance the project. For the economy as a whole, all investment projects whose real rate of return exceeds the real rate of interest will be undertaken. That is, investment is undertaken up to the point where r = i.

Exploration: How is the demand for investment goods related to the real rate of interest?

The graph illustrates the total dollar amount of investment projects whose expected real rate of return is at least r. For example, the graph shows that there are currently no investment projects whose expected rate of return is at least 12%, but $15 billion worth of investment projects whose real rate of return is at least 6%. To use the graph, click and drag on the blue diamond to adjust the real rate of interest; click and drag on the ID label to shift the investment demand curve.

1		What is the total dollar value of investment projects whose real rate of return is at least 8%? How much total investment will take place if the interest rate is 8%?
2		If the real interest rate falls from 8% to 4%, what happens to total investment spending?
3		Suppose a projected improvement in the economy increases the expected rate of return on every possible investment project by 2%. If the real interest rate is 6%, what will happen to total investment?
4		Explore on your own. What is the general relationship between the rate of interest, the real rate of return on investment, and total investment spending?

The aggregate demand – aggregate supply (AD–AS) model is useful for analyzing changes in both real GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to explain recession and unemployment, inflation, and economic growth.

Exploration: How do changes in aggregate demand and supply affect the equilibrium price level and real GDP?

The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The AD curve shows an inverse relationship between the aggregate price level and real GDP. This is because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which reduces consumption expenditures; and 2) makes domestically produced goods less attractive to foreigners, which reduces net exports.

The aggregate supply curve, on the other hand, reflects the costs of producing a given level of real GDP. At very low levels of real GDP, resources are unemployed and output may increase with little upward pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher production costs.

The economy is initially at the it's potential output, labeled Q₀, and the price level is stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the aggregate demand or aggregate supply curve, respectively, to a new location. Clicking Reset will restore the economy to potential output and a stable price level. Click Update to establish the new equilibrium as a starting point for additional analysis.

5		Starting from potential output, what will be the impact on real GDP and the price level of an increase in desired consumption expenditures?
6		Suppose the economy is operating at it's full potential and prices are stable. All else equal, will an increase in wages and salaries increase the aggregate price level?
7		Starting from a full-employment, stable price equilibrium, suppose aggregate demand decreases. Which will result in a deeper recession—if the price level falls or if it remains the same? Need a Hint?
8		The late 1990s were a period of dramatically rising stock values and rising labour productivity. Real GDP increased, yet prices remained relatively stable. How might this be explained by the AD–AS model?