Notes on Investment Demand and Economic Principles

Investment Demand

• Definition: Investment demand is the need for funds to make investments in the economy. It plays a crucial role in understanding economic growth and the health of the economy.

Return on Investment (ROI)

• What is ROI? - ROI stands for Return on Investment.

  • It measures how profitable an investment is by comparing the expected profits to the original investment amount.

  • Formula:
    $ROI = rac{(Expected Return - Investment Cost)}{Investment Cost} imes 100$

Key Relationships in Investment Decisions

• Real Interest Rate Calculation: The real interest rate is determined by taking the nominal interest rate (the stated rate) and subtracting the inflation rate.

  $Real ext{ Interest Rate} = Nominal ext{ Interest Rate} - Inflation Rate$

Example Scenario

1. Initial Situation:

   • Expected Rate of Return on a factory: 6%

   • Nominal Interest Rate: 8%

   • Inflation Rate: 1%

   • Real Interest Rate Calculation:

     • 8 ext{%} - 1 ext{%} = 7 ext{%}

     • Decision: Do not invest; borrowing costs are too high compared to expected returns.

2. Altered Situation (Inflation at 4%):

   • Nominal Interest Rate: 8%

   • Inflation Rate: 4%

   • Real Interest Rate Calculation:

     • 8 ext{%} - 4 ext{%} = 4 ext{%}

     • Decision: Still not advisable; returns do not exceed borrowing costs.

3. Final Situation (Inflation at 2%):

   • Real Interest Rate Calculation:

     • 8 ext{%} - 2 ext{%} = 6 ext{%}

     • Expected Return: 6%

     • Decision: It may seem unwise because it just breaks even, but this could still be a good option depending on other potential investments.

Importance of Real Interest Rate

• Investments should only be made if the expected returns are equal to or higher than the real interest rates. Understanding this can shift our thinking from a focus on accounting towards an economic perspective.

Borrowing Money vs. Retained Earnings

• Borrowing:

  • Borrowing is common for capital investments but carries risks related to interest rates.

  • Companies often use borrowed funds to maximize investment potential while managing associated costs.

• Retained Earnings:

  • These are profits that are not paid out as dividends but held for reinvestment.

  • Companies avoid keeping extra cash on hand due to inflation concerns.

  • It’s important to use retained earnings wisely to prevent losing value from inflation.

Example of Retained Earnings Utilization:

1. Investment Opportunity Consideration:

   • Companies examine where to best invest retained earnings, such as savings, short-term bonds, or reinvesting into growth opportunities like new factories.

   • Opportunity cost arises when retained earnings are used without considering higher-return investments.

   • Companies might decide between building a factory at 6% or investing in a bond at 8%.

2. Final Decision:

   • If a bond can provide a higher return than the potential factory investment, it might be more beneficial to choose the bond, illustrating opportunity cost in investment choices.

Wrap Up

• Key takeaways include the significance of ROI, real interest rates, and deciding between using retained earnings or borrowing for investments. Preparing to apply these concepts is vital for success in future exams and economic evaluations.