Question

Refer to the table in Figure 10.5 and suppose that the real interest rate is 6 percent. Next, assume that some factor changes such that the expected rate of return declines by 2 percentage points at each prospective level of investment. Assuming no change in the real interest rate, by how much and in what direction will investment change? Which of the following might cause this change: (a) a decision to increase inventories; (b) an increase in excess production capacity?

Short answer

The investment will decline by $5 billion, and the investment curve will shift toward the left.

Option (b): an increase in excess production capacity is the cause of investment decline.

Step-by-step solution

Change in investment curve

According to the given graph, the equilibrium level of aggregate investment at a 6% real interest rate is $25 billion.

Since the expected rate of return has declined by 2%, the investment at 6% expected rate of return will slip to the same investment at a 4% rate of return (shown by pink curve).

Therefore, the investment will fall by $5 billion (= 25 – 20), and the investment curve will shift to the left.

Reason for the shift in investment curve

A decision to increase planned inventories means increasing the investment on a project with a lower return rate. It is practically not possible. Also, increased investment will shift the curve to the right.

An increase in excess production capacity will decrease the investment demand because the firm already has unused machines to satisfy the production requirements. Thus, there is no need to increase the investment as the expected profit has declined.

Therefore, the curve will shift to the left.