Macroeconomics - Interest Rate and Investment Relationship (2024)

Interest Rate-Investment Relationship

The interest rate-investment relationship refers to the relationship between the interest rate and the level of investment in the economy. When interest rates are high, it becomes more expensive for businesses to borrow money to invest, which tends to reduce investment spending. Conversely, when interest rates are low, borrowing costs are lower, which encourages businesses to invest more.

Here is an example schedule illustrating the interest rate-investment relationship:

Assume that the interest rate in the economy is currently 8%.

From the above schedule, we can see that as interest rates rise from 6% to 10%, investment spending declines from $200 billion to $120 billion. This illustrates the negative relationship between interest rates and investment.

Shift in Investment Demand

Shifts in investment demand can be caused by various factors including:

• Acquisition, maintenance, and operating costs: Any changes in the costs associated with acquiring, maintaining, and operating capital goods can impact investment demand. For example, if the cost of machinery or equipment goes up, it may reduce the willingness of businesses to invest in new capital.
• Business taxes: Changes in taxes levied on businesses can also affect investment demand. For instance, if the government offers tax incentives for businesses to invest, it may encourage them to increase their investment spending.
• Technological change: Technological advancements and innovations can impact investment demand as well. For example, the introduction of new and more efficient production technologies can make investments in new capital goods more attractive.
• Stock of capital goods on hand: The current stock of capital goods held by businesses can also influence investment demand. If a company has a large amount of unused capacity, it may not see the need to invest in new capital goods.
• Planned inventory changes: Planned changes in inventory levels can also affect investment demand. For example, if a company plans to increase its inventory levels in the future, it may need to invest in new capital goods to accommodate the additional inventory.
• Expectations: Finally, investment demand can also be affected by expectations of future economic conditions. If businesses expect the economy to improve, they may be more willing to invest in new capital goods, while if they expect the economy to worsen, they may hold off on investing.