Investment Interest Rates

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.

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.

Fig. 1 - 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 r₁ and r₂, however, there are potential investments of cumulative values between v₁ and v₂ 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.

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

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.