Assignment: The Investment Schedule

1. The Investment Schedule. Suppose there is a firm that is considering whether to build a new factory. The factory will cost $100 to construct today, and will yield revenue of $110 a year from now. (For simplicity, we will assume the factory yields no further returns in future years).

(a) What is the return on capital from constructing the factory?

(b) Will the firm build the factory if the interest rate is 7%? If it is 12%? Explain.

Now suppose that instead of one firm, there are many firms that are considering whether to build a factory, each of which costs $100 to construct. The first factory will yield rev- enue of $120, the second revenue of $119, the third $118, and so on, decreasing by $1 for each additional factory built.

(c) Use the numbers above to draw the investment demand schedule for the economy.

(d) Suppose that the interest rate is 7%. What will be the level of investment in the econ- omy? (Note: you may assume that firms will build factories that just break even.)

(e) Now suppose that people become more optimistic about the future, and believe that factories will yield revenue $3 higher than they previously thought. Show what hap- pens to the investment demand schedule, and compute investment at the given 7% interest rate.

(f) Now suppose that expectations are at their previous level, but the interest rate rises to 12%. What happens to investment?