## 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.

A cake-making business currently has a small oven that can only bake small batches of cakes at a time. The cake business owner considers investing in a larger oven, which would increase output per hour and hopefully result in additional profits.**We are given the following values:**

\(\hbox{Cost of the oven - \$20,000}\)\(\hbox{Nominal interest rate - 15%}\)\(\hbox{Inflation rate - 10%}\)\(\hbox{Expected revenue - \$ 120,000}\)\(\hbox{Expected operating cost - \$ 98,000}\)We need to decide if the investment is profitable.**Solution:**Step 1. Find net expected revenue from undertaking this investment:

\(\hbox{Net expected revenue} =\)

\(= \hbox{Expected revenue} - \hbox{Expected operating cost} = \)

\(=\$120,000 - \$98,000 = \$22,000\)Step 2. Subtract the cost of the machine from the net expected revenue to find the expected profit:

\(\hbox{Expected profit} = \)

\(=\hbox{Net expected revenue} - \hbox{Cost of the oven} =\)

\(= \$ 22,000 - \$20,000 = \$2,000\)Step 3. We now need to find the expected rate of return. To do this, find what percentage the anticipated profit is from the oven cost.

\(\hbox{Expected rate of return} = \frac {\hbox{Expected profit}} {\hbox{Cost of the oven}} =\)

\(= \frac {\$2,000} {\$20,000} = 0.1 \ \hbox{or 10%}\)Step 4. To find the real interest rate, we subtract the inflation rate from the nominal interest rate:

\(\hbox{Real interest rate} =\)

\(= \hbox{Nominal interest rate} - \hbox{Inflation rate} =\)

\(= 15\% - 10\% = 5\%\)Step 5. To find the interest cost of the investment, we need to multiply the real interest rate by the total cost of the investment:

\(\hbox{Interest cost of the investment}=\)

\(=\hbox{Real interest rate} \times \hbox{Cost of the oven}=\)

\(= 5\% \times \$20,000 = \$1,000\)

Step 6. Finally, to find the total expected return, we multiply the expected rate of return by the total cost of the investment:

\(\hbox{Total expected return}=\)

\(=\hbox{Expected rate of return} \times \hbox{Cost of the oven} =\)

\(= 10\% \times \$20,000 = \$2,000\)

Step 7. Finally, we need to compare the marginal benefit and marginal cost of the investment:

\(MB \ \hbox{and}\ MC\)\(\hbox{Total expected return and Interest cost of the investment}\)\(\$2,000 > \$1,000\)Therefore, the owner of the business should undertake an investment.

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.

It can be seen from Figure 1 above that at r_{max}, there are no available investment opportunities that would yield such a rate of return. Between r_{1 }and r_{2}, however, there are potential investments of cumulative values between v_{1} and v_{2} available. Note that the values are cumulative. They are arrived at by aggregating all the possible investment projects and ranking them based on their rate of return from highest to lowest. The very last project added adds to the cumulative value at v_{max}, at which the rate of return is zero.The most important takeaway from the investment demand curve is that there is an inverse relationship between the real interest rate and the quantity of investment demanded. The real interest rate is shown on the vertical axis in Figure 1, along with the expected rate of return. This is because of the marginal benefit and marginal cost comparison that each firm is making when undertaking an investment. A firm will invest up to the point that it considers it profitable. Thus, it would invest up to the point where the expected rate of return is equal to the real interest rate. It will not invest at any point where the real interest rate is higher than the expected rate of return.

**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.

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.

From Figure 3 above, it can be seen that the 10-year real interest rate fluctuated between 1.3% and -0.4%, with an average of about 0.47%.Such changes in the real interest rate affect firms' decisions when deciding whether to invest or not and subsequently affect the total amount of investment in the economy.

## 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.

## References

- Federal Reserve Bank of St. Louis, Gross Private Domestic Investment 1970-2021, https://fred.stlouisfed.org/series/GPDI#0
- Federal Reserve Bank of St. Louis, Real Gross Domestic Product, 1970-2021, https://fred.stlouisfed.org/series/GDPC1
- Federal Reserve Bank of St. Louis, 10-Year Real Interest Rate, 2010-2022, https://fred.stlouisfed.org/series/REAINTRATREARAT10Y#0

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##### Frequently Asked Questions about Investment Interest Rates

How does interest rate affect investment?

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.

What effect do low-interest rates have on business investment?

Low-interest rates promote business investment as the cost of interest that the firms need to repay decreases.

Do high-interest rates encourage investment?

No, high-interest rates discourage investment as the cost of interest that the firms need to repay increases.

Do high-interest rates attract foreign investment?

No, high-interest rates discourage foreign economic investment, just like they discourage domestic investment.

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