Figure 15-3 The Interest Rate and the Firm’s Investment Demand
In Figure 15-2 , there is a negative relationship between the purchase
price of a computer and the stock of computers the firm wants to own.
Firms use many types of physical capital, however, including buildings,
factories, furniture, computer equipment, and various types of tools and
machines. Each different type of physical capital has a different price and
therefore it is impossible to think of any individual firm’s desired capital
stock in terms of any single price. For this reason, economists instead
focus on the negative relationship between the firm’s desired capital stock
and the market interest rate. Indeed, since firms use financial capital to
purchase their physical capital, it is natural to think of the interest rate as
the “price” of financial capital.
We just saw that when the interest rate falls, the PV of the future stream
of MRPs will rise. This increase in the present value of capital will lead
firms to increase their desired capital stock and thus the quantity of
investment demanded. The opposite happens when the interest rate rises.
We thus get a general prediction about firms’ investment behaviour:
Other things being equal, firms’ desired demand for investment (additions to physical capital)
is negatively related to the interest rate.This negative relationship is shown in Figure 15-3. The negative
relationship between the interest rate and the quantity of investment
demanded can be thought of as the firm’s demand curve for additional
physical capital where the relevant “price” is the interest rate.
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