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Investment Theory Explained

Have you ever wondered how investment decisions can affect the relationship between investment and the interest rate?
Here we explain the theory and also discuss the factors that affect a shift in the investment demand curve.

Investment theory

One of the factors of production is Capital, labour, and natural resources are part of the factors also. Public policy also has an effect on investment. Issuing bonds, the taxes and policy regulations that has been chosen by the public sector, can also have an effect on the choices of investments of both private organizations and individuals.
Quantity of investment graph
Source: mrmedico

Interest Rates and Investments

To demonstrate about the connection between interest rates and investment, assuming you’re a proprietor of a small factory and you are planning to install a solar energy system for your building. The total cost of the solar system installation would be $10,000, and the solar system will reduce your electricity bills by $1,000 per year. To make the example simple, we shall make an assumption that these savings will prolong and last for a life system, also that the solar system will never undergo any damaged condition nor service to keep the solar system functioning. In this way, we need to consider the amount, which is $10,000 invested and the yearly savings which is $1,000.

Assuming that your business has the money ($10,000) at hand already, you’re deciding between buying the solar energy system with the money or alternatively to purchase a bond. It is up to you to make a decision whether to buy the solar energy system or the bond, which will depend on the interest rate you could gain on the bond.

Investing $10,000 into the solar energy system will produce a fruitful income of $1000 every year – the saving the system will generate. That is a return of 10% per year. Assume the bond pay a 2% annual interest and produces interest income of $120 every year. Clearly, the solar system is the better use of your $10,000. However, if you do not have the $10,000 at hand presently, you would need to borrow the money to purchase the solar system. When the interest rates is below 10%, then it makes very good sense to borrow the money and invest in the system. But it is not advisable to borrow money when the interest rates is above 10%

In any given circumstances, millions of investments decisions are influenced by the interest rate. Every decision to put in money will be very good at some interest rates but not good at others. There is always a negative relationship between the interest rate and the level of investment.
Other Determinants of Investment Demand


Before making an investments decision, a business enterprise considers future sales; a student determine intrinsic value of prospects in various jobs and their required educational and training levels. As expectations become something different in a way that rise up the expected return from investment, the investment demand curve moves to the right.
Likely expectations of lowered profitability move the investment demand curve to the left.

The Level of Economic Activity

Firms would like capital to provide product and services. A rise in the level of production is probably going to increase demand for capital and result in larger investment. Therefore, a rise in GDP is probably going to shift the investment demand curve to the right. If the rise in GDP induces many companies to extend their investment, this multiplier factor impact are going to be even stronger.

The Stock of Capital

Suppose, for instance,  realty analysts expect that 100,000 homes are going to be required in a very specific community by 2010. That may produce a boom in construction—and so in investment—if this number of homes is 50,000 it’s impact will be less. Also, if the current stock of homes 99,980, no impact will be felt.

Capacity Utilisation

If a large proportion of the present capital stock is being used, companies will tend to increase investment. However, capital items are were idle, the utilization rate tends to fall and companies will employ unutilised assets before making further investments.

The Cost of The Capital Goods

In our example, if the development price of recent buildings rises, then the number of investment at any rate is probably going to fall. The investment demand curve so shifts to the left.
Other Factor Costs

A factory, for instance, may use a complicated capital facility and comparatively few staff, or it would use additional staff and comparatively less capital. The selection to use capital are going to be influenced by the price of the capital and therefore the rate of interest. If labour prices rise, the demand for capital is probably going to extend.
Our solar power system example suggests that energy prices influence the demand for capital further. The belief that the system would save $1,000 per annum in energy costs depends on the costs of fuel, gas, and electricity. If these costs were higher, the savings from the solar power system would be larger, increasing the demand for this type of capital.

Technological Change

The implementation of recent technology usually needs new capital. Changes in technology will also increase the demand for capital. Advances in technology have inspired large investments in computers and automated systems.

Public Policy

Public policy will have important effects on the demand for capital.
Accelerated depreciation, the investment decrease, and lower taxes on company profits and capital gains all increase the demand for physical capital. Public policy can even have an effect on the competition for alternative types of capital.

Key Takeaways

The quantity of investment demanded at any point in time is negatively affected by interest rates. This relationship is illustrated by the investment demand curve.
A modification within the rate causes a movement on the investment demand curve. A modification in the other determinant of investment causes a shift of the curve.
The other determinants of investment embrace expectations, the amount of economic activity, the stock of capital, the capacity utilization rate, the value of capital stock, alternative issue prices, technological modification, and public policy.

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If you have any questions about business or taxation, contact A2B today! We provide a range of specialist accounting services designed to save you time and money. Operating out of Capalaba near Brisbane and servicing businesses from all over Australia.

Call on 07 3823 2344 or fill out the form on our website.

Note: This article contains general information and has not considered your particular circumstances. Before you decide based on this advice, you should consult with an adviser, whether any action is appropriate to your financial circumstances. In addition, the examples provided on this site are only for illustrative purposes


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