Planned Investment and the Interest Rate

Real interest rates, which are adjusted for the rate of inflation, play a key role in determining planned investment. They are the cost of borrowing money to fund new projects.

Imagine an investor reviewing blueprints for a large-scale construction project. The investor must weigh the expected profit from the project against the cost of borrowing. If the interest rate is too high, the project's financing costs might exceed its potential return, causing the investor to put the project on hold.

Conversely, when rates fall, borrowing costs drop. More projects become viable, prompting the investor to move forward. Lower real interest rates encourage more investment.

This inverse relationship is illustrated by a downward-sloping investment demand curve, showing how investment levels respond to real interest rate changes.

For example, if the real interest rate rises from three percent to six percent, investment falls from I₀ to I₁. A further increase to nine percent reduces it to I₂. Lower rates would reverse this effect.

In summary, planned investment is negatively related to real interest rates : as interest rates increase, investment falls, and vice versa.