Difficulty: Intermediate to Advanced | Prerequisites: Parts 1 and 2 of these Ch. 12 notes
Parts 1 and 2 treated the interest rate as the main driver of planned investment. This final section broadens the picture: firms also base investment decisions on expected future sales, capacity utilisation, and the relative cost of capital versus labour. The appendix then introduces the IS-LM framework, a compact two-curve diagram that captures everything from the chapter in one graph. Some courses skip IS-LM, so check your syllabus, but the non-interest-rate determinants of investment are fair game for everyone.
Beyond the interest rate, planned investment rises when firms expect higher future sales, when existing capacity is being used heavily, or when capital becomes cheaper relative to labour. The IS-LM model plots the goods-market equilibrium (IS curve) and the money-market equilibrium (LM curve) on the same axes (r vs. Y) to find the economy's overall equilibrium.
Expected future sales
Firms' forecasts of what they will sell in coming periods. Optimistic expectations raise planned investment; pessimistic expectations lower it.
In simple terms, if a firm thinks demand is growing, it invests in more capacity now.
Capital utilisation rate
The fraction of a firm's existing plant and equipment that is currently in use. High utilisation signals that the firm is running near full capacity and may need to invest in more.
Think of it as how "full" the factory is. A nearly full factory nudges the firm to build more.
Relative cost of capital versus labour
The price of acquiring and operating capital goods compared with the cost of hiring workers. If capital becomes cheaper relative to labour, firms substitute toward capital (more investment). If capital becomes more expensive, firms lean toward labour instead.
IS curve (appendix)
A downward-sloping curve in (Y, r) space showing all combinations of aggregate output and the interest rate at which the goods market is in equilibrium. "IS" stands for Investment = Saving in the original Keynesian formulation.
In simple terms, it answers: for each possible interest rate, what level of output balances the goods market?
LM curve (appendix)
An upward-sloping curve in (Y, r) space showing all combinations of aggregate output and the interest rate at which the money market is in equilibrium. "LM" stands for Liquidity preference = Money supply.
In simple terms, it answers: for each possible level of output, what interest rate balances the money market?
The interest rate gets the most attention, but three other factors shift the entire investment schedule left or right:
Expected future sales. If businesses expect sales to grow, they invest more at every interest rate (the schedule shifts right). If they expect a downturn, the schedule shifts left. During the spring of 1991, low interest rates failed to stimulate investment partly because firms had pessimistic sales expectations and low capacity utilisation.
Capital utilisation rates. When utilisation is high, firms are bumping up against their capacity limits. They need new plant and equipment, so investment rises. When utilisation is low (lots of idle machinery), there is less reason to build more. Higher utilisation shifts the investment schedule right; lower utilisation shifts it left.
Relative cost of capital versus labour. If capital goods become cheaper relative to wages (perhaps because of a technology improvement or a tax credit on equipment), firms substitute capital for labour and planned investment rises. If labour becomes cheaper relative to capital, the incentive to invest in new equipment weakens.
These factors explain why investment can move even when the interest rate has not changed, and why monetary policy sometimes fails to stimulate investment despite lower rates.
The IS-LM model puts the goods market and the money market on one diagram with the interest rate (r) on the vertical axis and aggregate output (Y) on the horizontal axis.
The IS curve:
Slopes downward. A lower interest rate means more planned investment, more aggregate expenditure, and higher equilibrium output.
Each point on the IS curve is a (Y, r) pair where Y = C + I + G (goods-market equilibrium holds).
Shifts rightward with expansionary fiscal policy (higher G or lower T).
Shifts leftward with contractionary fiscal policy.
Does not shift when the money supply changes (that is the LM curve's job).
The LM curve:
Slopes upward. Higher output raises money demand; with a fixed money supply, the equilibrium interest rate must be higher.
Each point on the LM curve is a (Y, r) pair where M^d = M^s (money-market equilibrium holds).
Shifts rightward (downward) with expansionary monetary policy (increase in M^s).
Shifts leftward (upward) with contractionary monetary policy.
Does not shift when government spending or taxes change (that is the IS curve's job).
Overall equilibrium is where the IS and LM curves cross. At that point, both markets are simultaneously in equilibrium.
Expansionary fiscal policy: IS shifts right → both r and Y rise. The rise in r is the crowding-out channel.
Contractionary fiscal policy: IS shifts left → both r and Y fall.
Expansionary monetary policy: LM shifts right → r falls and Y rises.
Contractionary monetary policy: LM shifts left → r rises and Y falls.
Combining the two:
Expansionary fiscal + contractionary monetary: IS right, LM left → r definitely rises, Y is ambiguous.
Contractionary fiscal + expansionary monetary: IS left, LM right → r definitely falls, Y is ambiguous.
If a (Y, r) combination is to the right of the IS curve, output is too high for goods-market equilibrium at that interest rate (excess supply of goods). If it is above the LM curve, the interest rate is too high for money-market equilibrium at that output level (excess supply of money).
IS curve condition: Y = C + I(r) + G (For each r, solve for the Y that satisfies goods-market equilibrium.)
LM curve condition: M^d(r, Y) = M^s (For each Y, solve for the r that satisfies money-market equilibrium.)
No single algebraic formula is needed at the principles level. The key is graphical: draw the two curves, find their intersection, and show how policy shifts one curve or the other.
The non-interest-rate investment determinants explain episodes where rate cuts did not work as expected. In the early 1990s US recession, the Fed lowered rates aggressively, yet business investment barely responded because capital utilisation was low and firms were pessimistic about sales. The IS-LM framework is the standard tool intermediate macro courses use to analyse these situations, and it underpins how central banks and treasuries think about coordinating policy.
"If the interest rate falls, investment must rise." Only along a given investment schedule. If expected sales collapse or utilisation drops at the same time, the whole schedule shifts left, and investment can fall even as rates fall.
"The IS curve shifts when the money supply changes." The money supply shifts the LM curve. The IS curve shifts with fiscal policy (G and T changes) or shifts in autonomous spending.
"A point above the LM curve means there is a shortage of money." A point above the LM curve means the interest rate is too high for money-market equilibrium at that output, so there is an excess supply of money (people hold less money than is available and buy bonds).
"Capital utilisation and expected sales are the same thing." They are related but distinct. A firm can have high utilisation now but expect sales to decline, or low utilisation now but expect a boom ahead.
⚠️ Non-interest-rate investment determinants are a common source of exam questions. Know the three factors and the direction each pushes investment.
⚠️ If your course covers IS-LM: know which curve shifts for fiscal vs. monetary policy, and the direction of the shift.
⚠️ A frequent trap question describes a scenario where investment does not respond to lower rates and asks you to explain why. The answer involves the other determinants (pessimistic expectations, low utilisation, high relative cost of capital).
⚠️ IS-LM policy-mix questions: if both curves shift, one variable (r or Y) has a definite direction and the other is ambiguous. Identify which is which.
True or false: If capital utilisation rates fall, planned investment will rise. False. Lower utilisation means less need for new capacity, so investment falls.
True or false: If the cost of capital decreases relative to the cost of labour, planned investment tends to decrease. False. Cheaper capital relative to labour encourages firms to invest more.
True or false: The IS curve shows combinations of income and interest rates consistent with equilibrium in the goods market. True.
Fill in the blank: Expansionary fiscal policy shifts the ________ curve to the right. IS.
Fill in the blank: Expansionary monetary policy shifts the ________ curve to the right. LM.
Q: Which of the following events will lead to a decrease in planned investment: (a) a decrease in the interest rate, (b) businesses expect sales to decline, (c) capital utilisation rates increase?
A: (b) Businesses expect sales to decline. This shifts the investment schedule left, reducing planned investment at every interest rate.
Q: If capital utilisation rates increase, what happens to investment and why?
A: Investment increases. High utilisation means existing capacity is nearly full, so firms need to build more plant and equipment.
Q: In the IS-LM diagram, what policy shifts the LM curve to the left?
A: Contractionary monetary policy (a decrease in the money supply).
Q: An expansionary fiscal policy shifts the IS curve to the right. What happens to equilibrium r and Y?
A: Both the equilibrium interest rate and equilibrium output increase. The rise in r reflects the crowding-out channel.
Q: Which policy mix would definitely increase the equilibrium interest rate?
A: Expansionary fiscal policy combined with contractionary monetary policy (IS shifts right, LM shifts left; both push r up).
Q: If the investment demand curve is vertical, which policies are effective and which are ineffective?
A: Fiscal policy is fully effective (no crowding out because investment does not respond to the interest rate). Monetary policy is ineffective (changing r has no effect on I, so output does not change).
The non-interest-rate investment factors connect to the broader theme of business cycles: expectations, confidence, and capacity constraints drive investment swings that amplify recessions and expansions. The IS-LM model is the bridge to intermediate macroeconomics and to the AD-AS framework covered in later chapters, where price-level changes are added to the picture.
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