[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

20
18
INVESTMENT (AS % OF GDP)
16
14
12
10
8
6
1960 1965 1970 1975 1980 1985 1990 1995 2000
Figure 30.5
THE VARIABILITY OF
INVESTMENT
The share of investment in GDP has varied greatly in recent years. The investment boom
of the 1990s stands out clearly.
SOURCES: Economic Report of the President (2004), Table B-2.
INVESTMENT AND THE REAL INTEREST RATE
To undertake investment in new plants or equipment, firms must believe that the
expected future returns will be large enough to compensate them for the risks of the
investment. Moreover, firms are aware that a dollar in the future is worth less than a
dollar today; if they had the dollar today, they could put it in a bank and get back the dollar
with interest a year later. As the interest rate rises, future dollars are worth less relative to
today’s dollars. As a result, there will be fewer investment projects with future returns
large enough to offset the forgone interest. To put the relationship between investment
and interest another way, think of a firm as having to borrow money for the investment
project. As higher interest rates increase the cost of undertaking the project, fewer
projects will have an expected return high enough to yield a profit after those higher
interest costs are paid. Thus, higher interest rates lead to lower levels of investment.
The relationship between interest rates and investment is the investment function
introduced in Chapter 6. It is depicted as the downward-sloping curve in Figure
30.6. Of course, what matters for investment spending is the real interest rate, or the
cost of funds after taking into account the effect of inflation. If the nominal interest
rate increases but expected inflation increases by the same amount, firms’ investment
will be unaffected. (The real interest rate is the nominal interest rate minus the
expected rate of inflation.) When there is inflation, the dollars that the firm uses in
the future to pay back the funds borrowed today for investment will be worth less
than those borrowed dollars. If inflation is 5 percent, then each year, the value of
goods and services that a dollar can purchase drops by 5 percent. If the interest
rate is 8 percent, the real cost of the loan is only 3 percent (the 8 percent nominal
interest rate minus the 5 percent rate of inflation).
INVESTMENT ∂ 673