Chapter 9: Problem 3

How do you explain why investment falls as the interest rate rises?

Short Answer

Expert verified

Investment falls as the interest rate rises because higher interest rates increase the cost of borrowing. This deters firms from taking on debt to invest in new capital, thus reducing overall investment.

Step by step solution

Define Interest Rate

The first thing to understand is what an interest rate is. It's the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Assets borrowed could include, cash, consumer goods, and large assets like a vehicle or building.

Understanding Investment

Next, it's important to understand what is meant by the term 'investment'. In economic terms, investment refers to the accumulation of new capital, such as machinery, buildings, and goods stocked for sales in a business. It's important to emphasize that for a company to invest, it often needs to borrow money.

Significance of Interest Rates in Investment Decision

Now, the connection between this investment and interest rates can be made. Interest rates are significant in decision making about any form of investment. This is because when a business borrows money to invest in new capital, they must pay back the borrowed amount plus the interest rate charged.

Effect of Rising Interest Rates on Investment

Finally, when interest rates rise, the cost of borrowing funds to invest also rises. High interest rates make borrowing more expensive, so it deters firms from investing and can cause investment to fall as a result. It may also make projects that appeared viable with lower interest rates not financially feasible.

Summarising the Relationship

In conclusion, the relationship between interest rates and investment is inversely proportional. As interest rates rise, investment tends to fall (and vice versa) because the higher cost of borrowing deters firms from investing.