Relationship between Interest Rates and Investment - Essay Example

Name: Instructor: Course: Date: Relationship between Interest Rates and Investment Abstract The aim of this paper is to explore the short-term and long-term determinants of interest rates across different economies in greater detail, with a particular focus on the relationship between variations in interest rates and investment.It is based on the assumption that real interest rates are inversely related to investment. It analyzes the factors that are responsible for changes in real interest rates, and the impacts that these changes have on investments in the world’s economies. It also investigates whether nominal interest rates or real interest rates(or both) are responsible for changes in investment. Introduction The level of investment in an economy varies with changes in various determinants. These determinants include the expected return on investment, business confidence, changes in national income and interest rates. This essay seeks to investigate the influence of interest rates on investment and the relationship between the two across different economies. Is the relationship positive or negative? Are both nominal and real interest rates responsible for changes in investment or is it only real interest rates that have an influence on investment? Literature Review A majority of today’s empirical research and subsequent evidence on the determinants of real interest rates and its impacts on investment finds its roots in the extraordinary rise of rates in the early 1980s. One such analysis revealed that investment might have some impact on interest rates (Qing & Chong), while another, that the changes in interest rates have a sure effect on investment (Ingersoll & Ross). An investigation on the effect of changing rates on irreversible investment revealed a positive or negative effect on demand for investment by the changes in interest rate. (Alvarez & Koskela). While some scholars came to the conclusion that interest rate and investment were positively linked, others, using the VAR model, argued that interest rates had zero impact on investment (Dore). Even though the United States’ move to adopt a tight monetary policy is what triggered the initial surge, the effects of the adopted policy ended up being long-term, contrary to the expectation that they would only be short-term. With thisincredible rise in real interest rates in the mid-1980s, major research on their determinants was initiated (Blanchard & Summers;(Barro & Sala-i-Martin). However, by early 21st century, the global rates had gone unusually low, and economists were now focused on trying to explain the cause of that (Ahrend, et al.). Today, the world’s large economies, such as Japan, the United States, and Europe are experiencing negative short-term real interest rates and near zero long-term interest rates. The Situation of Interest Rate and Investment Changes in interest rates reflect the state of a country’s macro economy and have an effect on all other macroeconomic variables, including the rate of economic growth, GDP and price level (Wuhan & Khurshid). This makes the interest rate a very crucial variable in macroeconomics. It is directly related to economic growth (Alam & Uddin) but inversely related to investment (Albu). It is defined as the profit made over time due to financial assets or instruments, or simply, the price paid (by the borrower to the lender) for the use of money or assets for a given duration of time. This amount is conventionally charged as a percentage of the principal amount. From the lender’s point of view, the interest rate is the lending rate (fee charged for lending money), while for the borrower, the interest rate is the borrowing rate (cost of borrowing money). Great investors seek to make investments in an efficient market, which provides conditions that allow many individualsand businesses to make an extraordinary profit. In an inefficient market, however, fewer people are able to make these profits, causing potential investors to lose confidence in the market. In this market, if banks increase the interest rates paid out to individuals who deposit money with the banks, there is an eventual switch from share market capital to bank capital, thus decreasing the demand and price of share and vice versa. What is interesting though, is that when the same banks increase the interest rates paid to the same depositors, there is an increase in the lending interest, leading to a decrease in investments in the economy, hence a consequent decrease in share demand and share price and vice versa. This makes the relationship between interest rate and share price (and investment) inverse (Alam & Uddin). The inverse relationship between investments (I) and interest rate (r) is expressed in the expression below. I = e – f  r Where e is the minimum level of investments and f is how much the interest rate (r) affects the investments (I) negatively. This inverse relationship is as a result of two things. First, an increase in interest rates subsequently increases the opportunity cost of an investment, thereby increasing the return on funds put aside in a deposit account (deposit account with interest). It also increases the interest on loans, making it less likely for people to invest, at least not until interest rates have lowered again. The second reason for this inverse relationship is that firms are more likely to postpone their investment decisions in the event that interest rates go up. This is because consumers are likely to reduce their spending and to invest less, yet for firms to invest in their expansion, consumers need to maintain their present spending. Firms will, therefore, invest less in their expansion. Interest rates are constantly changing due to factors such as inflation rates and influence by the Central Bank (or Federal Reserve). High inflation means that lenders will be paid back at a value lower than what they rented out, and they, therefore, increase the interest rates in order to compensate for the decline in their money’s purchasing power. The Central Bank, on the other hand, plays the role of setting national monetary policy and overseeing overall banking operations of a country. It sets the primary interest rate of a country according to the present rates. When inflation is foreseen as a result of an expanding economy, the Central Bank will sharply increase short-term interest rates so that demand is reduced and individuals and businesses will not want to borrow so much money, thus reducing the rate of economic growth. However, the reverse is true. In a contracting economy, the Central Bank puts measures in place to reduce interest rates. This encourages individuals and businesses to borrow and spend more, thus boosting the economy. Changes in interest rates generally affect different types of investments, including stock prices and bonds (Albu). As companies pay extra for loans and raw materials, their profit margins are greatly reduced, thus reducing stock prices. Treasury bonds also suffer, as it becomes harder to make decent returns from these, even though they are generally considered to be safer investments than stocks. A surge in interest rates lowers bond prices, while falling interest rates push bond prices higher. Prevailing market rates determine the price at which bondholders will eventually sell. At interest rates higher than the bond rates, the bonds will sell for less, and vice versa. The more years the bond is from maturity, the bigger the price change. When interest rates go up, other rates and interest payments also go up, from credit cards to loans. It becomes more expensive to borrow, with borrowing costs and deposit rates going higher. This makes it difficult for individuals and businesses to borrow or save. With companies unable to borrow, expansion in the form of hiring,acquisitions,stock repurchases and capital investments is largely affected and slowed down. Individuals with loans spend a lot more on loan repayment interest, and therefore have less disposable income. This significantly reduces general consumption and investment (Albu). Payments on mortgages also go up, thus greatly minimizing consumer spending. A small increase in interest rates, say, 0.5%, will increase the cost of a £100,000 mortgage by a whopping £60 per month, which is quite significant. Those worst affected are first time house buyers in their 20s and 30s. With these increasing rates, people are therefore more likely to save their hard-earned money in a deposit account rather than spend it, as money deposited here gains some interest. They are also less likely to make risky purchases or investments or venture into risky businesses. This is because rising interest rates lower potential investors’ confidence about getting meaningful returns on their money. Higher interest rates also increase the amount of money that governments pay in terms of debt interest. For example, the UK currently pays more than £30bn annually on its national debt. The high cost of government interest payment subsequently leads to higher taxes, which are pushed on to businesses and consumers. Rising interest rates also increase/ strengthen the value of a country’s currency. As earlier stated, higher interest rates are likely to encourage more saving than spending or investing into the economy. Investors will, therefore, prefer to save their money in a bank in country with higher interest rates. This increase in the value of the currency will make the said country’s exports less competitive, thus increasing imports and reducing exports. This, coupled with a reduction in consumer spending and investment, reduces the economy’s Aggregate Demand (AD). A lower Aggregate Demand lowers a country’s economic growth, leading to a recession. Countries, such as the United States and the UK, have been on the receiving end of some of the worst recessions in history. The output is also greatly reduced as result of a lower AD, meaning firms produce fewer goods and therefore have need for less workers, hence an increase in unemployment. Another impact of a lower AD is that a country’s current account is improved. Higher interest rates eventually reduce the amount spent on imports, and lower inflation eventually helps to scale up the competitiveness of a country’s exports (Barro & Sala-i-Martin), thereby improving its current balance (see fig. 1 and 2) The effects of rising interest rates will often take a while before they are felt in an economy. This could be a period of anything up to 18 months. Investments already in place are therefore more likely to be hastened and finished by then, but new projects will be postponed until the rates are lower and relatively stabilized. In some instances, increasing rates will have a less effect on reducing the rate of consumer spending. In the housing industry, for instance, where increasing interest rates would normally discourage purchases, a continuous and rapid increase in house prices may serve as an incentive for people to continue spending, despite the rising interest rates. There are two types of interest rates. Nominal interest rates are usually agreed upon and indicated in contracts between the parties involved.Real interest rates, on the other hand, keep inflation into account (real interest rate = nominal interest rate – inflation). For instance, if interest rates went up from 4% to 5%, but inflation rose from 2% to 3.5%, this represents a reduction in real interest rates from 2% to 1.5% (i.e., from (4 - 2) to (6 - 1.5). Real interest rates, therefore, matter more for investment. Monetary policy is subject to the influence of interest rates. However, factors that determine and have an influence on investments and savings is brought about by drivers of authenticated interest rates (Wuhan & Khurshid). Conclusion Interest rate is a crucial, if not the most important macroeconomic variable of all, as its changes influence the rest of the other variables. Its link to and impact on investment is undeniable. Even though changes in inflation and interest rates cannot be fully controlled, countries can ensure steady local and foreign investments and subsequent economic growth by regulating their interest rates as per the current conditions, in order to maintain a stable economy. Fig. 1: Impact of interest rates on AD (source: www.economicshelp.org) Fig. 2: Effect of higher interest rates on AD (source: www.economicshelp.org) Works Cited Ahrend, R., Catte, P., & Price, P.,“Factors Behind Long-Term Interest Rates,”Financial Market Trends, OECD, No. 91, (November).2006 Alam, M. M., & Uddin, M. G. S., “Relationship between Interest Rate and Stock Price: Empirical Evidence from Developed and Developing Countries.” International Journal of Business and Management. 2009 Albu, Lucian-Liviu, “Trends in the Interest Rate – Investment – GDP Growth Relationship.” Romanian Journal of Economic Forecasting. 2006 Alvarez, Luis H.R., Koskela, E.,“Irreversible investment under interest rate variability.” 0404007, EconWPA. 2004 Barro, Robert J., & Xavier Sala-i-Martin,“World Real Interest Rates,” in NBER Macroeconomics Annual, edited by Olivier J. Blanchard, and Stanley Fischer: 15-61. 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M., “The Impacts of Interest Rate on Stock Market: Empirical Evidence from Dhaka Stock Exchange.”South Asian Journal of Management and Sciences, 1(2), 123-132. 2007 Wuhan, Li Suyuan, &Khurshid Adnan, “The effect of interest rate on investment; Empirical evidence of Jiangsu Province, China”,Journal of International Studies,Vol. 8, No 1, pp. 81-90. DOI: 10.14254/2071-8330.2015/8-1/7. 2015 Read More