International Finance Theory and Policy
by Steven M. Suranovic

Finance 50-3

Investment Demand

Investment demand refers to the demand by businesses for physical capital goods and services used to maintain or expand its operations. Think of it as the office or factory space, machinery, computers, desks, etc, used to operate a business. It is important to remember that investment demand here does not refer to financial investment. Financial investment is a form of saving, typically by households, who wish to maintain or increase their wealth by deferring consumption till a later time.

In this model investment demand will be assumed to be exogenous. This means that its value is determined outside of the model and is not dependent upon any variable within the model. This assumption is made primarily to simplify the analysis and to allow the focus to be on exchange rate changes later. The simple equation for investment demand can be written,

ID = I0

where the "0", or naught, subscript on the right side indicates that the variable is exogenous, or autonomous. In words, the equation says that investment demand is given exogenously as I0.

Admittedly, this is not a realistic assumption. In many other macro models, investment demand is assumed to depend on two other aggregate variables: GNP and interest rates. GNP may affect investment demand since the total demand for business expansion is more likely the higher is the total size of the economy. Also, the growth rate of GNP may be an associated determinant since the faster GNP is growing the more likely companies will predict better business in the near future, which may inspire more investment.

Interest rates can affect investment demand because many businesses must borrow money to finance expansions. The interest rate is the cost of borrowing money, thus, the higher are interest rates, the lower should be investment demand, and vice versa.
If we included the GNP and interest rate effects into the model, the solution to the extended model later would prove to be much more difficult. Thus we simplify things by assuming investment is exogenous. Since many students have learned about the GNP and interest rate effect in previous courses, you need to remember that these effects are NOT a part of this model.

International Finance Theory and Policy - Chapter 50-3: Last Updated on 1/20/05