Let us make an in-depth study of the relationship between the interest rate, desired capital stock and investment.

Using the neoclassical theory of investment, assume that the desired capital stock is a function of output and the interest rate.

By assuming output constant, the relationship between the interest rate and the desired capital stock may be plotted.

If the interest rate is plotted on the vertical axis and the desired capital stock on the horizontal, the relationship is shown in the left panel of Figure 8.10.

Thus, if the interest rate is z0, the desired capital stock is K0*. Should the interest rate decrease to i1, the desired capital stock increases to because, with a lower interest rate, it is profitable for firms to employ more capital.

Suppose the interest rate is i0 and the desired capital stock is K0*. If the actual capital stock, also measured on the horizontal axis, is K1, there is no discrepancy between the desired and actual capital stocks. Hence, net investment is zero.

Gross investment is, however, positive, since firms must invest to replace plant and equipment that has worn out or been destroyed. Consequently, at interest rate I0, investment is I0, which according to equation (iii), equals δ K0. This combination is shown in the right panel of Figure 8.10.

If the interest rate decreases to i1 the desired capital stock increases to K1*. Since the actual capital stock is A0, the desired capital stock exceeds the actual capital stock, and net investment is positive as firms add to their productive capacity.

But firms do not attempt to eliminate the gap between the desired and actual capital stocks in a single period; they do so over a number of periods. For example, suppose the desired capital stock exceeds the actual capital stock by \$20 billion.

If λ in equation (iii) equals one-half, net investment equals \$10 billion, obtained by multiplying λ by the difference between die desired and actual capital stocks. Consequently, at interest rate i1, gross investment equals I1, which consists of net investment, λ (K1* – K0), plus replacement investment, 6 A0. This combination is depicted in the right panel of Figure 8.10. Since I1 exceeds I0, an inverse relationship exists between the market rate of interest, i, and investment, I; as the interest rate decreases, investment increases.

Over time, the discrepancy between the desired and actual capital stocks will be eliminated. For example, suppose the interest rate remains at i1. So long as net investment remains positive, the capital stock increases, thereby reducing the discrepancy between the desired and actual capital stocks.

Since net investment equals λ, a constant multiplied by the discrepancy between the desired and actual capital stocks, investment will be less in succeeding periods, and the investment function of Figure 8.10 will shift to the left.