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Investment I depends on the expected present value of capital's future returns relative to its cost. A lower interest rate makes capital more valuable, increasing desired investment. Firms compare the marginal product of capital to the user cost of capital (which includes interest rates, depreciation, and taxes). Investment is more volatile than consumption because it is forward-looking and sensitive to expectations and interest rates.
From your study of net present value, you know how to evaluate whether a future stream of cash flows justifies a present outlay. Firms apply exactly this logic to capital investment. Buying a piece of equipment is worth it if the NPV of its expected future output exceeds its purchase price. The marginal product of capital (MPK) — the additional output produced by one more unit of capital — represents the benefit side. The user cost of capital represents the cost side: the opportunity cost of tying up funds in capital rather than earning the market return, plus the rate at which the capital depreciates, plus any taxes on capital income. The investment decision rule is simple: invest when MPK > user cost of capital, and stop when they are equal at the margin.
The interest rate enters through the user cost. When interest rates fall, the opportunity cost of deploying funds in capital drops, reducing the user cost. Some investment projects that were marginally unprofitable become viable. More fundamentally, the rate at which future cash flows are discounted falls, raising the NPV of long-lived investment projects. This is why investment spending is interest-elastic: it responds more strongly to interest rate changes than consumption does, because investment yields are concentrated in the future (discounting matters more) while consumption is largely a current-period decision. Monetary policy's primary transmission channel to the real economy runs through this relationship.
Expectations make investment far more volatile than consumption. A household deciding whether to buy groceries knows its current income with reasonable certainty. A firm deciding whether to build a new factory is betting on demand, input costs, competition, and the regulatory environment over the next 10–20 years. Small revisions to expected future profitability can reverse large capital investment decisions. Keynes famously described investment as driven by animal spirits — waves of optimism and pessimism that can shift investment dramatically without any change in "fundamentals." This forward-looking, expectation-sensitive character is why investment is the most volatile component of GDP, collapsing sharply in recessions and recovering erratically.
From your capital accumulation work, you know that investment drives long-run growth by expanding the capital stock. In the short run, investment fluctuations dominate business cycle dynamics because the investment-to-GDP ratio (roughly 15–20% of GDP) swings far more than consumption as a share of income. During the 2008–2009 recession, US business fixed investment fell over 20% while consumer spending fell only 3%. This asymmetry means investment demand shocks — driven by confidence, credit conditions, or expected future profitability — are a primary driver of aggregate demand fluctuations, and stabilizing investment expectations is one of the key channels through which monetary and fiscal policy aim to smooth economic cycles.