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Chapter 10: Q3. (page 214)

Why will a reduction in the real interest rate increase investment spending, other things equal?

Short Answer

Expert verified

A decline in the real interest rate means a decrease in the cost of investment. Thus, the investment spending increases due to lower costs.

Step by step solution

01

Meaning of investment demand

Investment demand is the demand for money/financial resources to fund the business activities like buying capital goods. The investment demand depends on the real interest rate, which is the cost of investment, and the expected profit rate, which is the investment return.

02

Inverse relationship between real interest rate and investment

As the real interest rate decreases, the cost of investment decreases. A lower cost encourages firms to demand more money for investment purposes and increase their production level. This would raise their expected return on investment. A higher expected rate of return stimulates the investment demand in the economy.

The investment demand is negatively sloped, as shown in the graph below:

When the real interest rate declines, the increasing investment is shown by the negatively sloped investment demand curve, ID0. Therefore, a decrease in the real interest rate increases investment spending, ceteris paribus.

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Most popular questions from this chapter

Suppose that an initial \(10 billion increase in investment spending expands GDP by \)10 billion in the first round of the multiplier process. If GDP and consumption both rise by \(6 billion in the second round of the process, what is the MPC in this economy? What is the size of the multiplier? If, instead, GDP and consumption both rose by \)8 billion in the second round, what would have been the size of the multiplier?

Use your completed table for problem 1 to solve this problem. Suppose the wealth effect is such that \(10 changes in wealth produce \)1 changes in consumption at each income level. If real estate prices tumble such that wealth declines by \(80, what will be the new level of consumption and saving at the \)340 billion level of disposable income? The new level of saving?

Level of Output and Income (GDP = DI)
Consumption
Saving
APC
APS
MPC
MPS
\(240
\)244
-$4
1.016
-0.016
0.8
0.2
2602600100.8
0.2
28027640.985
0.014
0.8
0.2
30029280.9730.0260.8
0.2
320308120.962
0.037
0.8
0.2
340324160.9520.0470.8
0.2
360340200.944
0.055
0.8
0.2
380356240.9360.0630.8
0.2
400372280.930.070.80.2

If a \(50 billion initial increase in spending leads to a \)250 billion change in real GDP, how big is the multiplier?

  1. 1.0

  2. 2.5

  3. 4.0

  4. 5.0

What are the variables (the items measured on the axes) in a graph of the (a) consumption schedule and (b) saving schedule? Are the variables inversely (negatively) related, or are they directly (positively) related? What is the fundamental reason that the levels of consumption and saving in the United States are each higher today than they were a decade ago?

In year 1, Adam earns \(1,000 and saves \)100. In year 2, Adam gets a \(500 raise so that he earns a total of \)1,500. Out of that \(1,500, he saves \)200. What is Adam’s MPC out of his $500 raise?

  1. 0.50

  2. 0.75

  3. 0.80

  4. 1.00
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