3.13: Planned Investment and the Interest Rate

Interest rates have a big impact on how businesses plan their investments. They show how much it costs to borrow money. When borrowing is cheap, it’s easier for businesses to take on new projects. However, when borrowing costs go up, it becomes harder to make investments that seem worthwhile.

Think about a local restaurant owner who wants to open a second location. If interest rates are low, getting a loan feels manageable, and the owner might be excited to grow the business. But if interest rates rise, the extra loan payments could make the new location too risky, and the owner might decide to put expansion plans on hold.

There is a clear pattern: investment usually goes down when interest rates go up. When rates go down, investment tends to rise. This idea is shown through a downward-sloping investment demand curve, meaning businesses invest less when borrowing gets more expensive.

In other words, if the interest rate jumps from three percent to six percent, many business plans that once made sense might now seem too costly. Investment could shrink from one level, call it I₀, to a smaller level, I₁. If rates climb again to nine percent, investment could drop even further to I₂. But if rates fall instead, more businesses find it easier to invest.

It’s also important to remember that the decision isn't just about numbers. Business owners often consider how confident they feel about future sales and the economy. But even with strong confidence, higher interest rates can be enough to hold back investment.

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.