Video transcript
In our planned expenditureremodel we've been assuming that planned investment is fixed. What I want to do inthis video is think about how real interest ratesdrive planned investment. Think about the function investment as a function of real interestrates. Planned investment as a function of real interest rates. Talking about realinterest rates, I'm really just talking about nominal interest rates factoring out ordiscounting what's going on with inflation. There'sother videos where we go into more depth aboutthat. Another thing if there were noinflation real and nominal rates would be the same thing. I want to tackle it witha very tangible example. Let's say this up comingyear there's a bunch of potential planned projects. Let's call this projects.Theses are potential investments. You haveprojects, and then you have some level of expected return. Each of the people who are thinking about these projects, they allhave their spreadsheets out, and they've takenin risk and probabilities and all of the rest. They've come up with their expected return numbers. Let's say project A hasan 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 ratesare relatively high. Let's R1 is equal to 19% interest rates. We have 19% real interestrates. 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 cashthey would definitely do this. If they don'thave the cash, they could say, well, I couldborrow 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 personactually has the cash on hand to do projectB, they say I could do project B and get an 18% real return, or I could lend thatmoney out and get a 19% in real return. Actually, I would not do project B. I'll just sayI would not do anything that has a even a lower real return. If I could potentiallydo 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 amoney loosing proposition. I wouldn't do B, and Idefinitely wouldn't do all these things that get a lower return. When I have high interestrates right over here the only thing I would do is project A. Let's think about whatwould 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 godown to ... let's say they go down to 3%. Onceagain, project A you are definitely goingto do. If you have the money on hand, you get20% doing project A. You definitely don't wantto lend it out at 3%. If you don't have themoney on hand, you can borrow at 3% and invest at 20%. By the same logic, peoplewould 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 lendit out and only get 3%. You'll even do projectE if you need to borrow it and still makes sense.Borrow money at 3%, invest it at 5%, yourmaking some real return. The only one that you would notdo is project F right over here. Here you aren't actuallycovering 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% thendo project F. So, your definitely not going todo F in this scenario. Obviously do it in neither scenario. Right over here, you'ddo all of the above. You would do A, B, C,D, not all of the above. All of the above exceptfor F. A, B, C, D, and E. Let's just think about therough level of investments. If we were to plot onthis axis right over here, if we were to plot theinvestments as a function of real interest rate,and over here we actually have the ... independentvariables are real interest rate. At a highreal 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 interestrates to R2, we had a much higher level of investment. We did all of theseprojects right over here. You had a much higher level of investment. This is A, B, C, D, andE. You see that you have an inverse relationship.The lower the real interest rate, the moreinvestment that's going to go on. The higher theinterest rate, the less investment that goes on. You can debate whetherit's a curve or a line, bur for the sake ofsimplicity, we'll assume that it looks somethinglike ... I'll draw a dotted line it's easier for me do that. It might look something like that. Now, we can use thisinsight to start thinking about how a change inreal 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.
