Consumption, Saving, Investment, and the Multiplier ❮ 97is the expected real rate of return (r) the firm anticipates receiving on the expenditure. The
marginal cost of the investment is the real rate of interest (i), or the cost of borrowing. Let’s
look at this concept with examples.Expected Real Rate of Return
A local pizza firm invests $10,000 in a new delivery car. The owner expects this to help
to deliver more pizzas, increasing revenues and profits. The car lasts exactly one year and
the increased real profits are anticipated to be $2,000. This expected real rate of return is
$2,000/$10,000 = .20 or 20 percent. Of course an actual car lasts more than one year, but
this decision to invest is shown for one year to keep it simple, while still making the point.Real Rate of Interest
The owner goes to the bank and asks for a one-year loan to purchase the new delivery
car. The bank offers a nominal rate of interest of 15 percent; this includes 5 percent for
expected inflation and 10 percent as the real rate of borrowing the money for a year. At the
end of the year, he spends $1,000 as real interest on the $10,000 loan.The Decision
Since the new delivery car provides $2,000 in additional real profits (r = 20%), and the
loan costs $1,000 in real interest (i = 10%), this investment should be made. Another way
to make this decision is with a comparison of interest rates.• If r% ≥ i%, make the investment.
• If r% < i%, do not make the investment.Investment Demand
Like any demand curve, the quantity demanded increases as the price falls. The same is true
for investment demand. The rational firm invests in all projects up to the point where the
real rate of interest equals the expected real rate of return (i = r). Very few investment pro-
jects are available at extremely high rates of return and so those opportunities are taken first.
As the real rate of return (r) falls, those very profitable opportunities are gone, but many
less profitable investments remain. So as the expected real rate falls, the cumulative amount
of investment dollars rises. Likewise, as the real cost of borrowing (i) falls, more and more
projects become worthwhile, so dollars of investment rises. Either way, as interest rates fall,
the total amount of investment rises. Figure 8.5 illustrates the investment demand curve,
which shows the inverse relationship between the interest rate and the cumulative dollars
invested. At an interest rate of 5 percent, $20 billion dollars might be invested.Investment and GDP
In the simple model of private investment outlined in Figure 8.5, there is no mention of
GDP or disposable income. With no government or foreign sector, GDP = DI. To keep the
model simple, we assume that investment spending (I) is determined from the investment
demand curve and is constant at all levels of GDP.Example:
In Figure 8.5 if the interest rate was 5%, firms would invest $20 billion this year,
regardless of the level of disposable income or GDP. This autonomous invest-
ment is illustrated in Figure 8.6 as a horizontal line with GDP on the x-axis.
If something happened to interest rates, or to investment demand, autonomousTIP