Investment Demand Curve
What is Investment Demand Curve?
The investment demand curve shows the inverse relationship between the real interest rate and the quantity of investment spending firms want to undertake.
It slopes downward because a lower real interest rate reduces the cost of borrowing (and the opportunity cost of using funds), making more capital projects profitable, so the quantity of investment demanded rises. A change in the real interest rate causes a movement along the curve, while shift factors, business expectations, technology, taxes on investment, and the existing capital stock, move the whole curve. This curve links the loanable funds market to the investment component of aggregate demand. It explains why expansionary policy that lowers real rates stimulates investment and AD.
Investment Demand Curve: a worked example
A firm ranks four capital projects by expected rate of return: project A at 12%, B at 9%, C at 7%, and D at 5%. Each costs $20 million. A project is worth funding only when its expected return exceeds the real interest rate. At a real rate of 8%, just A and B clear the bar, so quantity of investment demanded = 2 × $20 million = $40 million. Let the real rate fall to 6%. Now A, B, and C clear it, and investment demanded rises to 3 × $20 million = $60 million. Plot the two points, $40 million at 8% and $60 million at 6%, and the downward slope appears. Nothing about the projects changed. The firm simply slid down its own investment demand curve as borrowing got cheaper.
The mistake students make with investment demand curve
The classic error is shifting the curve when the interest rate changes. A student reads that the central bank pushed the real rate down, draws investment demand shifting right, and then reports a bigger rise in investment than the graph supports, counting one rate cut twice. A rate change moves the firm along a fixed curve. Ask what changed: if the answer is the interest rate, slide along; if the answer is anything else about the profitability of capital, shift the curve. Getting this backwards also breaks the handoff from the loanable funds diagram, where that rate was set in the first place.
Investment Demand Curve questions
Does the investment demand curve use the real or the nominal interest rate?
The real interest rate belongs on the axis, because a firm compares the inflation adjusted cost of funds against the real return its new capital will earn. A firm facing a nominal borrowing rate of 9% when expected inflation is 4% is really paying 5%, so a project returning 7% in real terms is still worth funding. Using the nominal rate would wrongly predict that investment collapses whenever inflation is high. Free response questions expect the real rate here and in the loanable funds market beside it.
What shifts the investment demand curve?
Anything that changes the expected profitability of capital at a given interest rate shifts the curve. Optimistic business expectations, new technology that raises the return on equipment, an investment tax credit, and lower business taxes all shift it right. Pessimism about future sales, higher taxes on investment returns, and a large existing capital stock that has already captured the best opportunities shift it left. A useful check on any candidate factor: ask whether it changes the expected return on a project without changing the cost of funds.
How does the investment demand curve connect to the loanable funds market?
The loanable funds market sets the real interest rate where the supply of saving meets the demand for borrowing. That rate then carries across to the investment demand curve, which converts it into a quantity of investment spending, and investment is a component of aggregate demand. Government borrowing that raises the real rate slides firms up their investment demand curve to a smaller quantity, which is the crowding out story drawn across two graphs. Expansionary monetary policy runs the same chain in reverse.
This is the live Loanable Funds sandbox. Drag the curves, or open the full version.
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