Investment demand function refers to the relationship
between level of investment and the cost of capital. The cost of capital is the real
interest rate. This relationship is very important because interest rate is the major
means available to governments to influence investment.
In
taking decisions on investment in any projects, firms compare the the revenue from the
project with the cost of capital, which depends on the rate of interest. The net of
revenue less the cost of capital represents the profit from the project. Then this is
positive the investment makes money, while a negative figure signifies losses. Firms
will therefore invest in a project only when the revenues form the project is higher
than the cost of capital. As the cost of interest, and with that cost of capital rises,
there are less projects that meets this condition. Therefor investment falls with
increase in interest rates, and rises with fall in interest rates. The exact
relationship between the interest rate and demand for investment will depend on
availability of opportunities for investing and their revenue
potential.
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