Relationship Between Interest Rate And Business Investment Spending

The Inverse Relationship Between Business Investment and Interest Rates

Question:

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

The purpose of this paper elucidates on the relationship between the interest rate and business investment spending. This has been explained in relation to the Reserve Bank of Australia lowering official cash rate (OCR) that led to other commercial banks in lowering interest rate for the borrowers (Bodie 2013). This affects the activities of the business as well as the customer’s habits of purchasing. Low rate of interest rate reflects existence of huge money in this economic system. On the other hand, higher rate of interest makes it expensive for the business organizations to borrow money that is used in financing the operations in the business. In addition, the rise in business investment owing to lower interest rate influencing the aggregate demand, real GDP and price level in the economy is also discussed in this report.

It has been opined by Smales (2012), business investment has inverse relation with the rate of interest that are basically borrowing cost and recompense to lending. The main reason behind inverse relation between investment and rate of interest are:

• Firstly, if the central bank of the nation raises the interest rate, then this increases the opportunity cost of the investment. Therefore, this reflects that increase in rate of interest raises the fund returns that is being deposited in the account that decreases the attractiveness in business investment in relation to lending (Cavusgil et al. 2014). However, business decision regarding investment might be postponed unless rate of interest moves to low level.
• Secondly, if the central bank of a particular nation lowers interest rate, then the entities might anticipate that the customers would increase their spending, as they will not prefer to save more. Hence, the organizations will also increase their investment spending and this boost the economy at times of adverse economic conditions.

Furthermore, it has been stated by many economists that lower rate of interest do not encourage business investment. In contrast to this, economic theory states that the interest rate set by the Central Bank influences the capital cost, which in turn affects the business decisions regarding investment that relies on the standard procedure used for evaluating opportunities of investment (Fraser et al. 2014).

In Australia, the Reserve Bank of Australia (RBA) has been trimming rate of interest despite low economic growth and unemployment rate. The main reason behind cutting of interest rate is that they want to spur investment in business (Galí et al. 2015). It has been seen from the recent study that business investment in this nation has been weak over the last few years and hence the policymakers reduces the rate of interest  for enhancing growth in nations productivity, employment and wages for long term. As the Australian government wants the organization to invest in huge amount for increasing the nation’s income, they have implemented various steps in reducing government budget deficit by decreasing expenditure.

The Role of Central Bank in Influencing Business Investment

When RBA reduces rate of interest, banks mainly charges low amount for business loans. This highlights that the organizations uses small amount of earnings for paying interest on the loans, which leads to rise in investment on operational activities of business. As a result, this will lead to increase in profits that in turn improve the financial performance of business.  The rise in profitability level is because the business earns huge amount from new ventures for paying for interest loan and thus having huge left over money for profit.  In addition, some entrepreneurs decide to begin new projects or expand their business in other countries during this period. However, this encourages the business owners in investing more on the business activities in order to increase growth of the organizations. It has been seen from recent studies that, as the rate of interest in low, the business saves less and invest more in purchasing new equipments as well as improving plants in order to increase productivity. On the other hand, this can benefit the sellers of equipment and other construction firms and hence banks lose out. Therefore, it can be seen from the above study that low interest rate set by RBA positively influences the business investment spending.

Rise in business investment affects the economic growth of the nation that is analyzed with the help of macroeconomic indicators that includes aggregate demand, price level or inflation rate and real GDP (Gitman et al. 2015). These economic indicators help in assessing economic health of the nation. Investment being the main constituent of aggregate demand, the aggregate demand curve shifts owing to variation in investment. In addition, variation in investment results in huge variation in aggregate demand in the short run. This means that increase in business investment shifts aggregate demand curve rightward by that amount at which it is equal to multiplier times the investment variation. When the federal government increases aggregate demand, it buys bonds. This leads to increase in prices of bonds, declines rate of interest and hence enhances business investment as well as aggregate demand in the economy. It has been stated by (), business investment responding to variation in rate of interest reflects effectiveness of monetary policy. Aggregate demand curve is negatively sloped that implies indirect relation between level of prices and real GDP.

Figure 1: Investment change affecting aggregate demand

Source: (As created by author)

The Impact of Interest Rate Changes on Business Investment in Australia

The above figure reflects that decrease in interest rate leads to rise in level of investment. This shifts the aggregate demand curve rightward and hence this positively influences real gross domestic product (GDP) of the economy (Krishnamurthy and Vissing-Jorgensen 2012). The real GDP of the economy increases but the price level decreases at the same time. As the price level declines, the consumer’s purchasing power increases and this improves the total income of the nation. Hence, this improves the economic growth of the nation (Hong and Yogo 2012).

Business investment increases capital stock and hence availability of capital amount is a vital determinant of productivity. However, as productivity in the economy rises, the nation income rises and this contributes to the growth of the economy.  For example, there are some companies that have decreased their highest payback period that shows that they might have increased discount rates for making investment decisions even if the RBA lowers interest rates. There are few evidences that the Australian firms attain higher profit due to this lower rate of interest. An organization in Bank Liaison program assesses discretionary capital spending by implementing DCF analysis. DCF analysis refers to the standard method that recommends by finance theory in evaluating investment opportunities (Wright 2012). This method also facilitates the firms in proposing the investment decisions because of rise in investment as interest rate declines. The discount rate that has been applied for analyzing DCF is also termed as ‘hurdle rate’. Moreover, changes in rate of interest impacts on the debt cost and under few assumptions, the equity cost also affects this hurdle rate.

For example, increase in investment in the mining industry of Australia expanded the real GDP in the first quarter of the year 2017 (Downes et al. 2014). According to the data released by Australian Bureau of Statistics (ABS) the GDP increased to 0.3% in this quarter from the previous year. However, increase in Australia’s mining investment spending rises consumption than retail sales in the last quarter. This increase in consumption was mainly due to lower savings rate of the households in Australia. The households in these nations saved less during this year owing to lower rates of interest that has been imposed by RBA. As a result, the real GDP increased and this improved the economic performance in this quarter. The economic issue that relates with the rise in investment causing rise in aggregate demand is decline in interest rate. Rate of interest mainly helps in establishing the total amount that consumers pay in borrowing. Low interest rate decreased monthly payments and hence business owners make huge investment in purchasing raw materials and advanced technologies. However, when the Australian government reduces rate of interest, the business organizations responds to decline in rates that has been offered to borrowers. Hence, decline in rate of interest basically leads to short term rise in aggregate demand, which in turn lowers price level and improves real GDP of this nation

Conclusion

From the above assignment, it can be concluded that decrease in rate of interest improves cash flows in the organizations through decline in interest payments, keeping up cash for several other business activities. This in turn influences total productivity and economic activities. The firms in Australia use effective discount rate for assessing spending opportunities. Thus, RBA decision in lowering official cash rate was appropriate for improving economic performance of this nation. Australian government plays a crucial role in rising business investment in order to raise income and improve economic conditions of the nation.

References

Bodie, Z., 2013. Investments. McGraw-Hill.

Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L., 2014. International business. Pearson Australia.

Cecchetti, S.G. and Kohler, M., 2012. When capital adequacy and interest rate policy are substitutes (and when they are not).

Downes, P.M., Hanslow, K. and Tulip, P., 2014. The effect of the mining boom on the Australian economy.

Fraser, P., Macdonald, G.A. and Mullineux, A.W., 2014. Regional monetary policy: An Australian perspective. Regional Studies, 48(8), pp.1419-1433.

Galí, J., 2015. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Gitman, L.J., Joehnk, M.D., Smart, S. and Juchau, R.H., 2015. Fundamentals of investing. Pearson Higher Education AU.

Krishnamurthy, A. and Vissing-Jorgensen, A., 2012. The aggregate demand for treasury debt. Journal of Political Economy, 120(2), pp.233-267.

Lane, K. and Rosewall, T., 2015. Firms’ Investment Decisions and Interest Rates. Reserve Bank of Australia Bulletin. June quarter, pp.1-7.

Smales, L.A., 2012. RBA monetary policy communication: The response of Australian interest rate futures to changes in RBA monetary policy. Pacific-Basin Finance Journal, 20(5), pp.793-808.

Wright, J.H., 2012. What does monetary policy do to long?term interest rates at the zero lower bound?. The Economic Journal, 122(564)

Hong, H. and Yogo, M., 2012. What does futures market interest tell us about the macroeconomy and asset prices?. Journal of Financial Economics, 105(3), pp.473-490.