Question

Which of the following scenarios will shift the investment demand curve right? Select one or more answers from the choices shown.

1. Business taxes increase.

2. The expected return on capital increases.

3. Firms have a lot of unused production capacity.

4. Firms are planning on increasing their inventories.

Short answer

The following options are correct:

• Option (b): The expected return on capital increases.

• Option (d): Firms are planning on increasing their inventories.

Step-by-step solution

Explanation for correct options

Option (b): Expected profit determines the investment decision on a project.If firms expect greater earnings from the project than its cost, they will invest more in the project. Therefore, if the expected return on capital increases, the investment demand will increase, and the investment demand curve will shift toward the right.

Option (d): Investment decisions are always associated with the planned investment. Firms plan to invest more in inventories if they want to increase their inventories for future needs. Hence, the expansion of inventories will raise the investment demand, and the demand curve will shift to the right.

Explanation for incorrect options

Option (a): An increase in business taxes will reduce the expected profit of the firms after taxes. Firms consider only the predicted profit earned after deducting taxes while deciding on an investment. It is because it goes directly to their pocket. Hence, increasing business taxes will reduce the investment demand and shift the demand curve toward the left.

Option (c): Firms get demotivated to invest more if they already have a lot of unused inventories. They are not able to sell the existing stock, so there is no use in adding more to the inventory. The expectation of profit on further investment declines, and investment demand decrease. Thus, the demand curve shifts to the left.