Question

Why will a reduction in the real interest rate increase invest- ment spending, other things equal?

Answer 1

A decrease in real interest rates lowers borrowing costs for businesses, leading to increased investment in physical capital as it becomes more attractive compared to financial investments. It also encourages consumer spending on big-ticket items, stimulating economic growth.

Step-by-step explanation:

A reduction in the real interest rate is likely to increase investment spending because it makes borrowing cheaper for businesses, which are more inclined to fund new investments in equipment, technology, and buildings when the cost of borrowing is low. As interest rates decrease, the opportunity cost of investing funds in financial assets rather than physical capital becomes less attractive, prompting firms to channel more resources into productive investment that may yield a higher return over time than the interest saved.

Moreover, lower interest rates make it more appealing for consumers to borrow for big-ticket items like houses and cars, which increases consumer spending and, in turn, stimulates economic growth. This scenario is particularly evident during loose or expansionary monetary policy periods, which aim to lower interest rates to encourage more borrowing and investing. Therefore, when considering the interest rate connection to investment, a decline in interest rates suggests an increase in the quantity of loanable funds, boosting business investment and consumer borrowing, contributing positively to aggregate demand.

Answer 2

A reduction in the real interest rate increases investment spending because it lowers the cost of borrowing for businesses and consumers, making investments more attractive and facilitating larger purchases, respectively. This leads to a rise in business activity and consumption, contributing to higher aggregate demand.

Step-by-step explanation:

A reduction in the real interest rate is likely to increase investment spending, with other conditions held constant. When interest rates are lowered, the cost of borrowing decreases, making it more attractive for businesses to finance new investment projects such as purchasing equipment or expanding operations. This is because lower interest rates reduce the expense associated with loans and other forms of financing, which can improve potential profitability of investments.

Furthermore, consumers are more likely to borrow for big-ticket items like houses and cars when interest rates are low, which also stimulates economic activity. If the cost of borrowing is less, consumers can afford to finance larger purchases, thus increasing consumption alongside business investment. This overall increase in consumption and investment spending contributes to higher aggregate demand within the economy.

The interest rate effect also ties to the overall economy; as lower interest rates increase the demand for money and credit, more funds are circulated through the economy, often leading to further investment and spending. In contrast, higher interest rates tend to discourage borrowing both by businesses for investment purposes and by households, thus reducing consumption and investment spending. It's important to note that periods of significant government borrowing can affect this dynamic, potentially leading to higher interest rates that could discourage private investment, a phenomenon referred to as 'crowding out.'