Unit 3 - Full Employment / Interest rate $ Investment demands

February 17, 2015

Full employment equilibrium exists where AD intersects SRAS & LRAS at the same point.

Recessionary gap exists when equilibrium occurs below full employment output.

Inflationary gap exists when equilibrium occurs beyond full employment output.

Investment rates and investment demand, investment is money spent or expenditures on:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• New homes
• Inventories (goods sold by producers)

Expected rates of return

• How does business make investment decisions? Cost/benefit analysis
• How does business determine the benefits? Expected rate of return
• How does business count cost? Interest cost
• How does business determines the amount of investment they undertake? Compare expected rate of return to interest cost
• If expected return > interest cost (then invest)
• If expected return < interest cost (then don't invest)

Real vs Nominal interest rate

• Nominal is the observable rate of interest i. Real subtracts out inflation (pie interest) and is only known ex post facto
• To compute real interest rate: R% (real) = i% (nominal) - pie (compute)