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Investment spending depends on the expected rate of return on capital relative to the cost of borrowing (the interest rate). Firms invest more when real interest rates are low and expected profits are high. The investment demand curve slopes downward: lower interest rates stimulate investment, increasing aggregate demand and output in the short run.
You've studied present value and discounting, which gives you the essential tool for understanding investment decisions. When a firm considers investing — buying a machine, building a factory, or hiring workers to expand capacity — it is trading a certain cost today for an uncertain stream of future profits. The fundamental question is whether those future profits, discounted back to the present, exceed the upfront cost. The interest rate enters this calculation twice: as the discount rate that converts future profits into present value, and as the opportunity cost of capital (funds used for investment can't be lent at the prevailing rate). This double role is why investment is so sensitive to interest rate changes.
Think about a firm evaluating a machine that costs $100,000 today and will generate $12,000 per year in net revenue for ten years. At a 5% interest rate, the present value of that income stream is approximately $92,600 — less than the cost, so the investment is not worthwhile. At a 3% interest rate, the present value rises to approximately $102,200 — now the investment is marginally profitable. Small changes in the interest rate flip the investment decision. Aggregate across thousands of firms considering similar marginal projects, and you get the investment demand curve: a downward-sloping relationship between the real interest rate and the total quantity of investment spending in the economy. When the central bank lowers interest rates, it simultaneously makes existing investment projects profitable and pulls new projects above the threshold.
This link between interest rates and investment is the primary transmission channel through which monetary policy affects the real economy. When the central bank raises rates to fight inflation, it raises the discount rate on future profits and the cost of borrowing — investment falls, aggregate demand contracts, and eventually output and inflation cool. The channel works in reverse when rates are cut to stimulate activity. This is also why business confidence and profit expectations matter so much: the numerator of the investment calculation is expected future profits. Even very low interest rates won't stimulate much investment if firms expect demand to be weak. This is the foundation of the "pushing on a string" problem — expansionary monetary policy can fail if pessimistic expectations dominate.
The investment demand curve shifts when anything changes expected returns independently of the interest rate. Technological progress that raises the productivity of capital shifts the curve right — each machine now generates more revenue, so investment is worthwhile at higher interest rates than before. Tax policy matters directly: an investment tax credit effectively lowers the cost of capital, while accelerated depreciation allows firms to deduct the cost of investment faster, raising the present value of the tax savings. Business cycle dynamics create an important amplification mechanism: when demand is strong, firms invest more to expand capacity, which raises income and demand further. This is the accelerator principle — investment responds not just to the level of output but to changes in output — which you'll explore in subsequent topics.