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Examine the contentions that all types of investment spending are inversely related to the real interest rate (Mankiw 2007:507)

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Macroeconomics Theory The work presented for assessment is all my own work and no form plagiarism in the representation of another person's work has taken place. Signature Date Question 1 - Examine the contentions that "all types of investment spending are inversely related to the real interest rate" (Mankiw 2007:507) Macroeconomics is a major element of economics it looks at the economy performance, structure and behaviour. It takes into account national income, unemployment, inflation, investment and international trade. Its aim is to understand the causes and consequence of short run fluctuations in national income with the long run understanding of economic growth. Both firms and households purchase investment goods, firms will purchases goods to add to there stock of capital or to replace existing capital as it wears out. Households in turn will buy new houses, which is also part of investment. Usually the quantity of goods demanded depends on the interest rate, which measures the cost of funds to finance the investment. For the investment to be profitable it returns must exceeds it cost of burrowed funds. ...read more.


Investment demand changes through the government tax laws. If the government was to increase personal income taxes and uses the extra income to cut tax for those who invest in new capital, such a change would make investment projects profitable increasing the demand for investment goods. A further look into nominal and real interest rate and how it is worked out, suppose you deposit your savings in a bank account that pays 8 percent interest yearly. Next year, you withdraw your savings along with the accumulated interest earned which makes you have 8% more money than when you first made the deposit a year earlier. Certainly you have 8% more money than you had before, but if prices have risen by a rate of 5%, and then the amount of goods you can buy has increased by only 3 percent, and if the inflation rate was 10%, then your purchasing power has fallen by 2%. Economists call the interest rate the bank pays the nominal interest rate and the increase in your purchasing power the real interest rate. ...read more.


The Market for loan able Funds in an open economy's saving S is used in two Ways: to finance domestic investment I and to finance the net capital outflow. S = I + CF. Consumption depends positively on disposable income the amount of income after all taxes have been paid. The higher the disposable income is the greater consumption will be. The quantity of investment goods demanded depends negatively on the real interest rate. For an investment to be profitable, its return must be greater than its cost. Because the real interest rate measures the cost of funds, a higher real interest rate makes it more costly to invest, so the demand for investment goods falls. When the government increases taxes, disposable income falls, and therefore consumption falls as well. For an investment to rise, the real interest rate must fall. Therefore, a tax increase leads to a decrease in consumption, an increase in investment, and a fall in the real interest rate. If a technological advance improves the production function, this is likely to increase the marginal products of both capital and labour. ...read more.

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