Question

Which of the following scenarios will shift the investment demand curve right? Select one or more answers from the choices shown. a. Business taxes increase. b. The expected return on capital increases. c. Firms have a lot of unused production capacity. d. Firms are planning on increasing their inventories.

Short answer

Options (b) and (d) will shift the investment demand curve right.

Step-by-step solution

Understand Investment Demand Curve

The investment demand curve shows the relationship between the interest rate and the level of investment. A rightward shift in the curve indicates an increase in investment at every interest rate.

Analyze Business Taxes Impact

Consider option (a). If business taxes increase, firms have less after-tax profit to invest, which would typically lower investment demand, not increase it. Therefore, option (a) does not cause a rightward shift.

Evaluate Expected Return on Capital

Consider option (b). An increase in the expected return on capital makes investment more attractive at each interest rate, leading businesses to invest more. Hence, this would cause a rightward shift in the investment demand curve.

Examine Unused Production Capacity

Consider option (c). If firms have a lot of unused production capacity, they are unlikely to invest more, as they do not need additional capital stock. This scenario would not cause a rightward shift in the investment demand curve.

Assess Inventory Plans

Consider option (d). If firms are planning on increasing their inventories, it implies that businesses expect higher future demand and profitability, leading to an increase in investment demand. This would cause a rightward shift in the investment demand curve.

Key concepts

Business Taxes

Business taxes have a significant influence on the investment decisions of a company. When business taxes increase, the cost of doing business goes up. This means companies have less profit left after taxes to reinvest into their operations. Higher taxes can often result in businesses tightening their budgets, reducing their investments in new capital or projects.

Conversely, if taxes are reduced, companies have more funds available, which can lead to increased investments. However, in the context of the investment demand curve, an increase in business taxes often shifts the demand curve leftward, indicating a decrease in investment. This is because firms generally have less incentive to invest in new projects when it is more costly due to higher taxes.

Expected Return on Capital

Expected return on capital is a critical factor that influences investment decisions. It is essentially the profit that investors anticipate gaining from their capital investments. When the expected returns on investment are high, businesses are more motivated to invest. This is because they foresee that the benefits will surpass the costs, leading to a profitable venture.

In terms of the investment demand curve, an increase in the expected return on capital causes the curve to shift to the right. This shift indicates that at every interest rate, the level of investment has increased. This is due to the increased attractiveness of undertaking new investments as companies expect to yield higher returns than they previously did.

Unused Production Capacity

Unused production capacity refers to a situation where a company is not utilizing its full production potential. It means there are idle resources or machinery that are not being put to use. In such a scenario, businesses generally hesitate to invest in further capital production.

If there's already significant excess capacity, companies have little need to build more factories or buy additional machinery. This lack of necessity can result in a leftward shift or no shift in the investment demand curve, representing reduced or unchanged investment demand. Firms prefer to utilize their existing resources before considering new investments.

Inventory Planning

Inventory planning is the process where firms decide how much inventory to hold. When firms plan to increase their inventories, it is often a signal of anticipated future demand. Companies expect that more goods need to be available to meet future customer needs, and thus, they prepare by expanding their inventory.

This signal of future growth leads businesses to invest more in production and inventory management, eventually influencing a rightward shift in the investment demand curve. This shift suggests that the firms expect higher profitability and are therefore willing to increase their level of investment in response to anticipated future demand.