In our planned expenditure remodel we've been
assuming that planned investment is fixed.
What I want to do in this video is think about
how real interest rates drive planned investment.
Think about the function investment as a
function of real interest rates. Planned investment as
a function of real interest rates.
Talking about real interest rates, I'm really
just talking about nominal interest rates
factoring out or discounting what's going on
with inflation. There's other videos where we
go into more depth about that. Another thing
if there were no inflation real and nominal
rates would be the same thing.
I want to tackle it with a very tangible example.
Let's say this up coming year there's a bunch
of potential planned projects.
Let's call this projects. Theses are potential
investments. You have projects, and then you have
some level of expected return.
Each of the people who are thinking about
these projects, they all have their spreadsheets
out, and they've taken in risk and probabilities
and all of the rest. They've come up with
their expected return numbers.
Let's say project A has an expected return of
20%, B 18%, C 16%. I'll do a couple more.
D is 10% , E is 5% and F is 2%. Let's say initially in one state
of affairs interest rates are relatively high.
Let's R1 is equal to 19% interest rates.
We have 19% real interest rates. These are the
real expected returns. Which of these projects
will actually be invested in?
Which of the ones will people actually do?
If someone has the cash, they say well,
I could either lend my money out for 19%,
or I could do this project and get 20%.
If they have the cash they would definitely
do this. If they don't have the cash, they could
say, well, I could borrow the money for 19%,
and I could invest it at 20%. I'll make money off of that.
Project A will definitely be done.
What about project B?
Project B, if the person actually has the cash
on hand to do project B, they say I could do
project B and get an 18% real return,
or I could lend that money out and get a 19%
in real return. Actually, I would not do
project B. I'll just say I would not do anything
that has a even a lower real return.
If I could potentially do project B, but I had
to borrow the money, if I have to borrow the
money at 19% real interest, and I'm only
getting 18% on it, that's a money loosing proposition.
I wouldn't do B, and I definitely wouldn't do
all these things that get a lower return.
When I have high interest rates right over here
the only thing I would do is project A.
Let's think about what would happen if interest
rates went down.
If real interest rates went down.
Let's say real interest ... let's call that R2.
Real interest rates go down to ... let's say
they go down to 3%. Once again, project A you
are definitely going to do. If you have the
money on hand, you get 20% doing project A.
You definitely don't want to lend it out at 3%.
If you don't have the money on hand, you can
borrow at 3% and invest at 20%.
By the same logic, people would do project B.
You could borrow at 3% and make 18%.
If you have the money, you get 18% verses 3% on
your money, so you definitely do this.
You do all of these up to project E.
If you have the money, you would rather put that
money and get 5% then lend it out and only get 3%.
You'll even do project E if you need to borrow
it and still makes sense. Borrow money at 3%,
invest it at 5%, your making some real return.
The only one that you would not do is project F right over here.
Here you aren't actually covering your cost of
borrowing. If you have to borrow at 3% and
invest at 2%, doesn't make sense.
If you have the money, you would rather lend
your money at 3% then do project F. So, your
definitely not going to do F in this scenario.
Obviously do it in neither scenario.
Right over here, you'd do all of the above.
You would do A, B, C, D, not all of the above.
All of the above except for F. A, B, C, D, and E.
Let's just think about the rough level of investments.
If we were to plot on this axis right over here,
if we were to plot the investments as a function
of real interest rate, and over here we actually
have the ... independent variables are real
interest rate. At a high real interest we had
a low level investment. We only did project A.
That's right over there. That's A only.
This is when we were at R1.
When we lowered interest rates to R2, we had a
much higher level of investment.
We did all of these projects right over here.
You had a much higher level of investment.
This is A, B, C, D, and E. You see that you have
an inverse relationship. The lower the real
interest rate, the more investment that's going
to go on. The higher the interest rate, the less
investment that goes on.
You can debate whether it's a curve or a line,
bur for the sake of simplicity, we'll assume
that it looks something like ... I'll draw a
dotted line it's easier for me do that.
It might look something like that.
Now, we can use this insight to start thinking
about how a change in real interest rate might
shift our plan expenditures on our
[unintelligible 05:50] and from that we can
start to think about the IS curve.
The famous IS curve and the ISLM model.