Question

Assuming that the following table represents the investment demand schedules for Country A and Country B.

Interest Rate	Country A’s Investment	Country B’s Investment
10%	$10	$70
8%	$50	$75
6%	$90	$80
4%	$130	$85
2%	$170	$90

• Plot the respective investment demand curves of Country A and Country B. How is investment related to interest rate? How does this manifest in the graph?

• How would you characterize the responsiveness of investment spending to the interest rates in Country A compared with Country B?

• Assuming an MPC of 75%, what would be the effect on real GDP in Country A and Country B if real interest rates decline from 8% to 6%?

Answer 1

A.

The investment demand curve of country A and B, shows that investment demand decreases with rise in interest rate and vice versa. It is manifested in the graph, by downward sloping nature of investment demand curve. It shows the negative slop where the investment demand is in inverse relationship to the interest rate. when interest rate increases, then investment demand decreases and vice versa.

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B.

The investment demand curve of country A is relatively more elastic in nature, in comparison to that of country B. It makes country A to be more responsive to the interest rate as far as the investment demand is concerned. It is the reason that investment demand curve of country is a more flatter, while investment demand curve of country B is more steeper.

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C.

MPC = 75%

So,

investment spending multiplier = 1/(1-MPC) = 1/(1-75%)

investment spending multiplier = 4

So, when real interest rate decreases from 8% to 6%, then there is an increase in investment demand that will increase the real GDP of country A.

Increase in investment demand = 90-50

Increase in investment demand = $40

So,

Net increase in real GDP of country A = 40*4

Net increase in real GDP of country A = $160