(b) Discuss what influence the rate of interest might have on the level of investment in an economy [15]
This paper discusses the influence the rate of interest might have on the level of investment in an economy. Investment refers to a process of accumulating capital, where goods are used in the production of other goods. There are two types of investment, the first being fixed capital such as machineries, plants and equipment, and second type of investments includes inventories such as raw materials and unsold goods. The cost of borrowing money or the cost of credit is important for businesses that depend on borrowed capital. The decision to invest depends on the expected returns on investment (MEI) and cost of investment (i/r). Investments will be profitable as long as MEI is more than interest rate. Hence the rate of interest definitely has an impact on investment, although there are some limitations and other factors that need to be considered in this paper.
There exists an inverse relationship between interest rates and investments. If the rate of interest decreases, then investment will increase, ceteris peribus. Projects with lower expected returns will now appear profitable and so more investments will occur. When interest rates are at 4%, projects with returns of 2% and below appears unprofitable I*, and will not be undertaken. If it falls to 2%, these projects will now become profitable, thus investments increase.
THINK: Insert theoretical diagram. What economics diagram do you think this will be?
Also, when rates of interest falls, people may save less but can consume more. This may increase production and employment and national income in the economy. Producers that need to meet higher consumption will invest more.
The extent of increase in the level of investment due to a fall in interest rates depend on the responsiveness of investment decisions to interest rate changes which in turn depends on economic conditions, business confidence and source of investment. Keynes suggested the interest elasticity of demand for capital goods – during a recession – businesses are pessimistic, and even decreases in interest rates may fail to stimulate investments.
Interest rates alone are also insufficient to influence the level of investment, but the expected yield is also crucial in determining investments. The expected returns are important in that a fall in interest rates that is accompanied by a fall in expected returns may not result in greater investment. Even without any increases in interest rates, if the MEI curve shifts up, there will be more investment at each interest rate than before. The increase in expected returns could result from either a fall in the cost of capital goods, increased efficiency of machines due to technological advancement or favourable changes in government policy such as decreases in profit taxes or any increase in business confidence.
Expected yield may end up being more important in certain circumstances – for example in Singapore, where investment is largely foreign. Most investments take place when businesses are optimistic about the profitability of their projects. The reduction in corporate tax for example, will increase the expected yield of business projects and encourage greater investment expenditures.
Therefore, the rate of interest is only one of many factors that affect the level of investment in an economy. Its impact depends on the responsiveness of the investment to interest rates. If the elasticity of investments to interest rates is elastic than an increase in interest rates will lead to more than proportionate increase in investments and vice versa.
JC Economics Essays - Economics Tutor's Comment: This economics paper could be improved. However, this is quite a good approach, although many relevant real life, real world examples are lacking and more details could be further added. This economics paper is quite strong in theory and the candidate clearly knows her work. Although it was written under model "A" level examination conditions, still think - how could this economics paper be further improved and made better? How could the conclusion be made more argumentative, more evaluative, more considered and better nuanced? Remember that an evaluative conclusion that gives a susbstantiated, justified, and nuanced opinion can score high, good marks. Suggested possible exam grade: 11.5 / 15.
