An Alternative to Fiscal Policy?
If we want to stimulate more production, why not rely on increasing investment? We know it will have the same "multiplier effect" as government spending, and in the long run it will also lead to increased productivity.
It appears that:
- If the government has enough control over business to control investment, then you have a planned economy, which will fail for other reasons.
- If the market is free enough for capitalism to "do its thing," then the government can influence investment only weakly and indirectly.
HOWEVER
- Indirect influence might still be better than no influence, and
- We don't really know for sure that it would be a weak influence.
Interest
One important variable that would influence investment is the rate of interest.
Interest is a key cost of investment.
- If the investor must borrow to invest, clearly he or she must make enough to pay the "note," i. e. to repay the loan with interest.
- Even if the investor takes the money from his or her bank account, the investor must give up the interest -- and that's an "opportunity cost."
Interest and Profitability
Interest is a cost, so we expect that higher interest will mean lower profits. Indeed, the profitability of an investment can be judged by the rate of interest it could pay and still be profitable.
An investment will require an outlay now, and will pay out net revenues only over some period in the future.
So the way to judge whether the investment is profitable or not is to discount the future net revenues for each year to present value, add them all up, and deduct the initial investment.
- Internal Rate of Return
- The rate of interest at which an investment will just break even is called the "internal rate of return" for that investment.
|
Rate of Discount |
5.00% |
6.25% |
7.00% |
|
|
|
|
| Year |
Payback |
|
|
| 1 |
-$100000000.00 |
-$100000000.00 |
-$100000000.00 |
-$100000000.00 |
| 2 |
$0.00 |
$0.00 |
$0.00 |
$0.00 |
| 3 |
$10000000.00 |
$9070294.78 |
$8857715.66 |
$8734387.28 |
| 4 |
$10000000.00 |
$8638375.99 |
$8336477.89 |
$8162978.77 |
| 5 |
$10000000.00 |
$8227024.75 |
$7845912.68 |
$7628952.12 |
| 6 |
$10000000.00 |
$7835261.66 |
$7384215.08 |
$7129861.79 |
| 7 |
$10000000.00 |
$7462153.97 |
$6949686.37 |
$6663422.24 |
| 8 |
$10000000.00 |
$7106813.30 |
$6540727.76 |
$6227497.42 |
| 9 |
$10000000.00 |
$6768393.62 |
$6155834.58 |
$5820091.05 |
| 10 |
$10000000.00 |
$6446089.16 |
$5793590.67 |
$5439337.43 |
| 11 |
$10000000.00 |
$6139132.54 |
$5452663.24 |
$5083492.92 |
| 12 |
$10000000.00 |
$5846792.89 |
$5131797.89 |
$4750927.96 |
| 13 |
$10000000.00 |
$5568374.18 |
$4829814.06 |
$4440119.59 |
| 14 |
$10000000.00 |
$5303213.51 |
$4545600.65 |
$4149644.48 |
| 15 |
$10000000.00 |
$5050679.53 |
$4278111.96 |
$3878172.41 |
| 16 |
$10000000.00 |
$4810170.98 |
$4026363.81 |
$3624460.20 |
| 17 |
$10000000.00 |
$4581115.22 |
$3789429.94 |
$3387345.98 |
| 18 |
$10000000.00 |
$4362966.88 |
$3566438.58 |
$3165743.90 |
| 19 |
$10000000.00 |
$4155206.55 |
$3356569.29 |
$2958639.16 |
| 20 |
$10000000.00 |
$3957339.57 |
$3159049.89 |
$2765083.33 |
|
|
|
|
|
sum |
$111329399.07 |
$100000000.00 |
$94010158.03 |
|
net |
$11329399.07 |
$0.00 |
-$5989841.97 |
|
Rate of Discount |
5.00% |
5.40% |
7.00% |
|
|
|
|
| Year |
Payback |
|
|
| 1 |
-$100000000.00 |
-$100000000.00 |
-$100000000.00 |
-$100000000.00 |
| 2 |
$0.00 |
$0.00 |
$0.00 |
$0.00 |
| 3 |
$30000000.00 |
$27210884.35 |
$27005118.95 |
$26203161.85 |
| 4 |
$30000000.00 |
$25915127.96 |
$25621733.79 |
$24488936.31 |
| 5 |
$30000000.00 |
$24681074.24 |
$24309214.98 |
$22886856.36 |
| 6 |
$30000000.00 |
$23505784.99 |
$23063932.29 |
$21389585.38 |
| 7 |
$0.00 |
$0.00 |
$0.00 |
$0.00 |
|
... |
... |
... |
... |
| 20 |
$0.00 |
$0.00 |
$0.00 |
$0.00 |
|
|
|
|
|
sum |
$101312871.55 |
$100000000.00 |
$94968539.90 |
|
net |
$1312871.55 |
$0.00 |
-$5031460.10 |
The Marginal Efficiency of Investment
Think of a very small economy in which just five investments are being considered. Column one enumerates the five investments from the most to the least profitable.
| Project |
Investment
Cost |
Internal Rate
of Return |
Total Investment |
| Shoe Factory |
$10,000,000 |
12% |
$10,000,000 |
| Bottling Plant |
$12,000,000 |
10% |
$22,000,000 |
| Distillery |
$8,000,000 |
9% |
$30,000,000 |
| Hydro Plant |
$20,000,000 |
5% |
$50,000,000 |
| Subway System |
$900,000,000 |
1% |
$950,000,000 |
Figure 1: The MEI in a Very Small Economy
We have just explained why investment depends on the rate of interest. But we haven't yet allowed for inflation. Interest, too, must be adjusted for inflation. Following the pattern, the adjusted interest rate is called "real interest."
- Nominal interest
- Nominal interest is the rate of interest specified in loan contracts, without adjustment for inflation.
- Real interest
- The real interest rate is the nominal interest rate minus the rate of inflation, and thus is the interest rate adjusted for inflation.
To be correct, we should say that investment depends on "real interest."
"NOMINAL" INTEREST
The nominal rate of interest is the rate written on the bond or mortgage. For example, on my house mortgage (in 1991), the nominal rate of interest was 10%. That's the rate that was written in my loan contract.
- MY REAL INTEREST
- In 1991, I paid interest of 10% on the outstanding principle of my mortgage, but the rate of inflation was about 5%, so I will pay the remaining balance back in dollars worth 5% less -- a gain to me. The difference, 10%-5%=5% is the real interest I paid.
- THE BANKER'S REAL INTEREST
- Similarly, the bank made 10% interest, but lost 5% of the purchasing power of the remaining balance for a net gain of 5%.
Money, Again
We see that
- Equilibrium production depends on investment
- Investment depends on the interest rate
and from the "liquidity preference" approach --
- the interest rate depends on the supply of money.
Figure 3. Liquidity Preference
The Inverse Relation of Interest and Bond Prices
Let's think about a simpler kind of monetary system.
- Suppose that monetary assets get no interest at all.
- Second, suppose the only other asset besides money is bonds.
- The bonds were issued in units of 1000 and pay interest of 6%, that is, $60 on a $1000 bond.
- Suppose the price of bonds goes up to $1200. Then the rate of interest is $60/$1200 = 5%
- But suppose the price of bonds were to rise very high, say to 2000, so that the rate of interest would be $60/2000 = .03 = R2.
Interest and Bond Prices
The quantity of money is Ms.
Suppose the interest rate is R1 = 6%. At that interest rate people want to shift Ms minus M1 of their assets from money into bonds. Thus they increase the demand for bonds, and that pushes the price of bonds up, and the interest rate down.
Suppose the interest rate is R2 = 3%. At that rate of interest, people want to shift M2 minus Ms of their assets from bonds to money. The competition to sell the bonds will push the price of bonds down below 2000, and so the interest rate will rise above R2.
Adjusting the Money Supply for Inflation
Shouldn't the quantity of loans and the quantity of money be adjusted for inflation, like just about everything else?
YES!
- Real money balance
- A real money balance is the nominal value of the balance divided by a price index. In this way, the money balance is adjusted for inflation, so that a given real money balance has a stable purchasing power.
Inflation Reduces the real Supply of Loans
Here a round of inflation has reduced the purchasing power of a constant nominal money supply from Mb to Ma, pushing the interest rate up from Rb to Ra.
Why is Aggregate Demand an Inverse Relationship?
We now have the basics of a complete theory of aggregate demand -- that is, a theory of why the aggregate demand for real GNP drops as the price level rises.
- An increase in the price level reduces the purchasing power of a given money supply
- The lower real money balances reduce the supply of loans
- The decrease in the supply of loans increases the price of loans, the interest rate
- The increase in the interest rate reduces investment
- The reduction in investment reduces real GDP demanded through a multiplier effect.
Figure 6: Aggregate Demand Scheme
Aggregate Demand
Monetary Policy
- Monetary Policy
- Changes in central bank policy or in bank reserved, designed to influence the interest rate and thus investment, production and employment, are called monetary policy.
For example, if the monetary authority in the United States, the Federal Reserve, wants to stimulate increased production, they would do it by increasing bank reserves. Recall, the method of increasing bank reserves is to buy bonds from the public or from the banks, since the Fed pays for the bonds with deposits in the Federal Reserve Bank System, and these deposits are bank reserves. The banks then expand the money supply by lending some multiple of the increased reserves. This, of course, increases the supply of loans, driving down the real interest rate. In response to the lower interest rate, investment rises, ceteris paribus. This is called "expansionary monetary policy."
Liquidity Trap and Monetary Policy
The monetary authority targets an interest rate of R2 to stimulate production at the full employment level; but expanding the money supply will not push the interest rate below the liquidity trap level R2.
Summary on Aggregate Demand
- Just what is aggregate demand?
- At every price level, the real GDP demanded is the sum of the four categories of planned expenditure: consumption, investment, government purchases, and net exports. The aggregate demand curve is the relation that tells is what this sum total is, for each respective price level.
- Why does it "work like" a demand curve? In particular, why is the aggregate demand curve downward sloping?
- A rise in the price level reduces the purchasing power of a given nominal supply of money, ceteris paribus. This reduces the supply of loans, and that, in turn increases the interest rate. The rise in the interest rate causes a reduction of investment, which in turn reduces equilibrium expenditure by a multiplier effect.
Summary
- Interest is a key cost of investment. Indeed
- The profitability of investment can be expressed by the "internal rate of return," that is, the highest interest rate at which the investment would break even. Therefore
- The higher the interest rate, the less investment can be profitably undertaken.
- This defines an inverse relationship between interest and investment, the marginal efficiency of investment.
- The interest rate in turn depends on the supply of money.
- For these purposes, both the interest rate and the supply of money are adjusted for inflation -- real interest and real money balances.
- Therefore, an increase in the price level will reduce the real value of a given nominal money supply, putting up interest rates, and therefore putting down investment and production.
- This is the basis for a an aggregate demand relationship that we can put more confidence in that we put in reasoning by analogy.