Investment Interest Rates: Effect & Relationship (2024)

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Have you ever tried to borrow something from your friend or roommate? Well, if you did, you will know that borrowing usually comes with some strings attached. The more you had to give for borrowing the item from your friend, the more you felt like you didn't want to borrow it anymore. We all know the feeling! How did you weigh your considerations regarding borrowing from your friend? Well, you probably considered the costs and the benefits; this is what the firms do when making investment decisions in economics. They balance the marginal costs with the benefits of an investment, which results in what is known as the interest-rate–investment relationship in macroeconomics. It is a little more involved, so buckle down and let's get started!

Relationship between Interest Rate and Investment

What is the relationship between the real interest rate and investment? Well, simply put, it is an inverse relationship. But let's not get too far ahead and remind ourselves what investment is in economic terms. Investment in economics is the allocation of funds by firms towards buying capital goods, machinery, equipment, or inventory. All these are expected to increase the firm's profits in the future.

Investment is the allocation of funds by firms towards something they expect will generate future economic benefits. It includes buying capital goods, machinery, equipment, or stockpiling inventory.

Effect of interest rates on investment

So, what is the effect of interest rates on investment? The firms weigh the marginal costs and benefits of their investment decisions. They will undertake an investment only if the marginal benefit outweighs the marginal cost. So what are these marginal benefits and costs of an investment?The marginal cost of the investment is the cost of acquiring capital for the firm; in other words, it is the interest rate. The marginal benefit of the investment is the expected rate of return on the investment. A firm will only undertake an investment if it is profitable for it to do so. In other words, the firm would invest if the expected return outweighs the interest rate of investment. Let's take a look at an example to understand this better.

Consider a sourdough bread bakery. It has five employees and no machinery for the most laborious process in sourdough production - kneading. All the kneading is currently done by hand, takes a lot of time, and is not as efficient as a kneading machine. The business owner considers whether it is worth undertaking such an investment.We are given the following values:\(\hbox{Cost of the kneading machine - \$10,000}\)\(\hbox{Interest rate - 5%}\)\(\hbox{Expected rate of return - 10%}\)We need to decide if the investment is profitable.Solution:The marginal benefit of the investment is the expected rate of return:\(\hbox{MB = 10%}\)The marginal cost of the investment is the interest rate:\(\hbox{MC = 5%}\)The marginal benefit of the investment outweighs the marginal cost:\(MB > MC\)\(10\% > 5\%\)Therefore, the owner should undertake this investment.

The expected rate of return is a percentage of the profit from an investment out of its total cost.

Let's consider another example to better understand the expected return and investment interest rate.

What is important to see from the above example is that the real interest rate matters rather than the nominal one. Even if the investment seemed unprofitable initially, when inflation is considered, it becomes clear that it should be undertaken.

The Investment Demand Curve

What is the investment demand curve? The investment demand curve aggregates total investment demand for all businesses in the sector.The investment demand curve shows an inverse relationship between the expected rates of return on projects and the total value of investment opportunities. Think about it: the higher the 'price' of investment, the lower the potential profit will be as a percent of that investment. Figure 1 below shows the investment demand curve.

The investment demand curve shows the relationship between the real interest rate and the amount of investment demanded in an economy.

Simply put, if the real interest rate increases, firms will demand less investment. Conversely, if the real interest rate decreases, firms will demand more investment, other things being equal.

The Average Interest Rate on Investments

Before we dive into the average interest rate on investments, let's understand what affects investment. Investment is generally very volatile, and there are good reasons why. Think about it: when considering an investment project, firms are required to make predictions about the future, and any fluctuation in their opinion on what the future might hold will affect their choices.Investment is generally affected by the following:

1. Corporate taxes. The firms make their calculations for net or after-tax profits when making investment decisions. Consequently, when the corporate tax rate increases, there will be fewer investment projects undertaken.2. Operating costs. Operating costs required to acquire, maintain and use the item that the firm plans to invest in will eat into the net profit margin. The higher the operating costs are for an individual firm, the less investment it will undertake.

3. Excess capacity. The more excess capacity that the firm has, the less it will invest because returns on investment decline compared to when the firm runs out of spare capacity.

4. Technological progress. The higher the rate of technological progress, the more the firms will invest. This is because technology improves productive processes making them more efficient and even viable in some cases.5. Firms' expectations. As firms are required to make predictions about the future, any changes in firms' expectations will lead to more or less investment undertaken. Favorable expectations will encourage investment, whilst unfavorable predictions would discourage investment. Firms can make expectations about almost anything: from the sales of their product and future profitability to political changes and even consumer tastes.As a lot of factors affect investment, it is pretty unstable. Figure 2 below shows how much investment fluctuates.

Fig. 2 - GPDI and GDP in the USA, 1970-2021. Source: Federal Reserve Bank of St. Louis ^1,2

Figure 2 above shows gross private domestic investment (GPDI) and gross domestic product (GDP) in the USA between 1970-2021 in real terms. It can be seen how volatile investment is, which is represented by the pink line. To give you a perspective on volatility, the swings in GPDI are greater than swings in the real GDP of the whole country!Finally, let's take a look at some more data and see the average interest rate on investments. Figure 3 below shows the 10-year real interest rate in the USA between 2010-2022.

Fig. 3 - 10-year real interest rate in the USA, 2010-2022. Source: Federal Reserve Bank of St. Louis³

Investment Interest Rates - Key takeaways

• Investment is the allocation of funds by firms towards something they expect will generate future economic benefits. It includes buying capital goods, machinery, equipment, or stockpiling inventory.
• The expected rate of return is a percentage of the profit from an investment out of its total cost.
• The investment demand curve shows the relationship between the real interest rate and the amount of investment demanded in an economy.
• If the real interest rate increases, firms will demand less investment. Conversely, if the real interest rate decreases, firms will demand more investment, other things being equal.

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