Question

How is it possible for investment spending to increase even in a period in which the real interest rate rises?

Short answer

Investment decisions are about comparing the marginal cost and marginal benefit. The marginal cost of investment is the interest rate, and the marginal benefit is the expected rate of return.

Other factors that influence investment demand can shift the investment demand curve. If these other factors shift the investment demand curve to the right, at the same time when the real interest rate is rising, investment spending can increase even when the real interest rate increases.

Step-by-step solution

Inverse relationship between investment and real interest rate 

An investment demand curve shows an inverse relationship between investment and real interest rate when other things remain constant. The real interest rate is the cost of investing; higher real interest means a higher cost of investment, which reduces the demand for investment.

For example, if the interest rate increases from 2% to 4%, the investment demand decreases from $200,000 to $100,000.

Reasons for the increase in investment along with the hike in real interest rate

Given the real interest and investment relationship, investment can increase with an increase in real interest rate if there are changes in other factors, which shifts the investment demand curve to the right. These reasons could be as follows:

A fall in acquisition costs, operating costs, and business taxes increase the cost and revenue gap, resulting in higher profits. This stimulates investment demand.

Technological change provides a chance to increase productivity and raise higher revenue by increasing the supply. This encourages firms to increase investment spending, and demand for investment increases.

The stock of inventories and planned inventories decide the need for investments. If there’s a lack of inventories in stock and firms need to increase their output, they will invest in new capital in spite of the high real interest rate.