Final answer:
The relationship between interest rates and investment quantity is directly related, with lower interest rates stimulating investment and higher rates discouraging it.
Step-by-step explanation:
Interest rates significantly influence the quantity of investment by firms. When interest rates are lower, it reduces the cost of borrowing and stimulates investment spending. Conversely, higher interest rates increase the cost of borrowing, leading to reduced investment spending.
Assuming the government borrows a substantial amount, this will shift the demand curve for financial capital to the right, demonstrating an increased demand.
This increased demand leads to a higher equilibrium interest rate in financial markets, as illustrated by a shift from Do to D₁, with the new equilibrium (E₁) at an interest rate of 6% and a quantity of 21% of GDP.
The expectations of future profits also motivate firms to invest, and during economic growth, investment tends to rise. For instance, U.S. investment levels rose in the late 1990s due to a high degree of business confidence.
However, during recessions, like in 2001 and 2009, investment levels dropped due to firms lacking funds and incentives to invest.
Interest rates are not only determined by domestic factors but also influenced by foreign financial investment and savings levels.
For example, during the mid-1980s and the Great Recession, government budget deficits did not result in a significant drop in private investment since private saving and inflow of foreign investment balanced it out.