Question

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

Short answer

A decline in the real interest rate means a decrease in the cost of investment. Thus, the investment spending increases due to lower costs.

Step-by-step solution

Meaning of investment demand

Investment demand is the demand for money/financial resources to fund the business activities like buying capital goods. The investment demand depends on the real interest rate, which is the cost of investment, and the expected profit rate, which is the investment return.

Inverse relationship between real interest rate and investment

As the real interest rate decreases, the cost of investment decreases. A lower cost encourages firms to demand more money for investment purposes and increase their production level. This would raise their expected return on investment. A higher expected rate of return stimulates the investment demand in the economy.

The investment demand is negatively sloped, as shown in the graph below:

When the real interest rate declines, the increasing investment is shown by the negatively sloped investment demand curve, ID₀. Therefore, a decrease in the real interest rate increases investment spending, ceteris paribus.