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Relationship between Interest Rates and Business Investment

1.Do you think that a fall in interest rate would lead to an increase in business investment? Why?

2.Assume that there has been a rise in business investment in response to the lower interest rates, what would happen to aggregate demand curve, real GDP and price level? Discuss using an appropriate diagram?

The present study is based on macroeconomic analysis by considering current steps taken by the Australian Prime Minister for better management of the current situation of the country. The study is bifurcated into two parts. The first part of the study deals with the relationship of interest rate and business investment and consequence on investment if interest rate reduces. The second part of the study is based on the relationship of aggregate demand and business investment and consequence on aggregate demand if business investment increases. For better understanding description is supported by appropriate examples and theories.

1. Owing to the step taken by the Australian Prime Minister of cutting down expenditure in all fronts, to reduce government budget deficit resulting in reluctance among people to spend and invest, the Reserve Bank of Australia has lowered the official cash rate, and consequently, commercial banks have lowered their interest rates for the borrowers. 

Lower Interest rates persuade people and businesses to make the additional investment, boost the spending potential, which ultimately gives rise to the economy in the phase of sluggish economic growth. The Reserve Bank of Australia is in charge of setting interest rates for Australia through monetary policy use (Mankiw, 2014). The RBA adjusts interest rates in order to affect the market demand for goods, services investments, borrowings and businesses. Interest rate fluctuations have an immense effect on the stock market, inflation in the market, investments made by people, borrowing capacity of business and the economy as a whole. RBA’s most powerful tool to reduce insecurity among public and raise their investment spending and thereby push the country out of phase of the recession (Baker, Bloom and Davis, 2016). Therefore reducing the interest rates would naturally lead to increase in business investment.

The reason behind the logic of lower interest rates and higher investment capacity is that lower rates signify the presence of ample amount of money to get into the system. With lower cash reserve rates banks have huge cash on hand, which raises their interest to lend it to people and businesses, and therefore, they reduce the interest rate on bank loans, overdrafts and current accounts (Malkiel, 2015). Another side of the reduced rates of interest is also reflected in the more competitive price of goods and services, all because it lowers the financing cost of operations, manufacturing and distribution processes for companies. This also attracts people to make or raise investment into the stock market which would result in higher returns than the bank deposits and bonds. This eventually makes credit card debt more expensive in comparison to other loans, since their money can earn high returns on several other investments, they use their extra money for paying down their credit cards. Thereby ultimately RBA uses monetary policy to stabilize the economy. The RBA controls the central fund rate influencing long-term interest rates, charged by banking institutions internally for overnight loans of reserves needed to meet minimum reserve requirements, eventually leading to increased investment spending, employment in market, output and inflation.

Aggregate Demand and Business Investment


Lowered interest rates help in business planning too. During this time companies plan for expansion since the cost of expansion is lowered. Due to such expansion, employment is generated leading to higher pay scales (Lung, 2014). Eventually, money flows into the consumer sector with attractive options of purchases, resulting in increased consumer purchases. More buying due to more spending capacity leads to higher prices, more profits and more production to meet growing consumer demand, and the cycle goes on.

In  Macroeconomics the relationship of investment and interest rate is best described by the investment/saving (IS) curve, a graphical representation of two intersecting curves. IS-LM model is a variation of the income-expenditure model integrating the interest rates in the market (demand), while the liquidity preference/money supply equilibrium (LM) curve portrays money available for investing (supply).

The model helps to explain in a pictorial form, decisions of investors with money available and the amount of interest they will receive. The state of Equilibrium is achieved when the amount of investment is equal to the amount available to invest. Another relationship is the money market, where the volume of money demanded increases with collective income and decreases with the interest rate.  The IS curve is the negative relationship between interest rate and output.

2. Aggregate Demand: Aggregate Demand is the summation of overall demand of goods and services in the economy. It’s the macroeconomic term which defines the relationship between each and everything purchased with the boundaries of country and its prices. Everything purchased is same as everything produced within the country. It is equivalent to the gross domestic product of that economy (Cingano, 2014).

Aggregate demand curve reflects the quantity demanded at each price in the economy. It is same to same as demand curve in microeconomics . It shows how demand changes in response to price.

  1. Consumer Spending: It’s the amount which an individual spends on final goods and services which are not used for investment. Goods purchased for resale are not included in this. They are considered as an investment.
  2. Investments spending by business: It includes spending on equipment’s, building, machinery and inventory.
  3. Government spending on goods and services: It doesn’t include unilateral payments such as Social security, Medicare and Medicaid because these don't increase demand (Choi and Holmes, 2014).
  4. Difference between Exports and Imports: It is net of exports from imports of goods and services within an economy.

Aggregate Demand= C+I+G+(X-M)

As per views of Burdekin and Langdana (2015), if there is a fall in interest rates then it will lead to increase in business spending and spending on final goods and services. In Short run, a rise in business investment will lead to change in Aggregate Demand. It will shift the aggregate demand curve towards the right. Considering an example if interest rates are reduced from 7% to 5 % and it has increased business investment by $50 billion per year. Assuming that multiplier is 2 then Aggregate Demand curve will shift rightwards by $100 billion. At the price level of 1.0 GDP demand rises from $8000 to $8100.

Components of Aggregate Demand

Investment adds to the capital stock of capital and amount or quantity of capital available to an economy is a crucial factor in its productivity. Increase in investment also causes an upward shift in production possibility curve. It also implies that in the Long run also Aggregate Demand curve will take a forward shift if there is an increase in investment. In the long run, it also increases the nation’s stock of capital and as well as human capital. Apart from reducing the interest rates, there are also other factors which increase the Aggregate Demand i.e. Increase in Consumer Spending’s, Increase in Exports or Decrease in Imports and Increase in Government Expenditure on final goods and services (Balassa, 2014). The increment in these factors will lead to rightward in AD Curve. All of these effects are the inverse of the factors that tend to decrease aggregate demand.

Reduction in official cash rate will lead commercial banks to reduce the lending rate for borrowers. Simultaneously it will reduce the intensity of individuals for savings and will motivate them and business to spend on investments. Accordingly, with the increase in investment Aggregate demand will also increase in both short run and long run. In the long run, this will not also increase the physical capital of the nation but also the human capital of the nation.

Conclusion

In accordance with the present study; it can be concluded that interest rate and business investment has a negative correlation as with the reduction of interest rate there is an increase in business investment. Further business investment and aggregate demand of economy shares positive relationship as with the increase in business investment there is a right shift in aggregate demand curve of the economy which shows an overall increment of demand in the economy.

References

Baker, S.R., Bloom, N. and Davis, S.J., 2016. Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), pp.1593-1636.

Balassa, B., 2014. Development Strategies'. International  Economics and Development: Essays in Honor of Raúl Prebisch, p.159.

Burdekin, R. and Langdana, F., 2015. Budget deficits and economic performance (Routledge Revivals). Routledge.

Choi, D.F. and Holmes, M.J., 2014. Budget deficits and real interest rates: a regime-switching reflection on Ricardian Equivalence. Journal of Economics and Finance, 38(1), pp.71-83.

Cingano, F., 2014. Trends in income inequality and its impact on economic growth.

Lung, T.Y., 2014. The Influence Study of Investment Optimization Timing Toward Debt Financing Under Interest Rate Uncertainty by Data Probability Analysis. Journal of Information and Optimization Sciences, 35(4), pp.379-385.

Malkiel, B.G., 2015. Term structure of interest rates: expectations and behaviour patterns. Princeton University

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Willett, T.D. and Laney, L.O., 2014. Monetarism, budget deficits, and wage push inflation: the cases of Italy and the UK. PSL Quarterly Review, 31(127).

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[Accessed 29 February 2024].

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