Interest rates and business investment - chain of reasoning

In this short revision video we walk through an example of a chain of reasoning on the link between a rise in interest rates and a change in business capital spending in an economy. We add a little evaluation into the mix as well!

Analyse how a rise in interest rates might affect total planned business investment

Investment spending by businesses is capital spending on hardware, software, plant and machinery and new factories.

A rise in interest rates indicates a tightening of monetary policy. One effect is likely to be a fall in planned capital spending by businesses.

This is because loans to finance investment projects are likely to become more expensive.

This will then lead to a fall in the expected real rate of return on capital investment. Some businesses may decide to postpone projects.

The negative effect on planned investment will be amplified if higher interest rates causes a fall in consumer demand for goods and services.

This fall in demand will then lead to an increase in spare productive capacity and is also likely to cause a worsening of business confidence.

Brief evaluation perspectives

1. Effect on investment depends on whether banks and other lenders decide to pass on higher interest rates set by the central bank via increased market rates on loans. Small businesses are likely to be hit as a result.
2. Interest rates are only one factor among many affecting planned investment. A business might be able to fund capital spending using their own resources such as retained profits.
3. The pace of technological change in an industry might be rapid leading firms to have to replace capital more frequently and the prices of new capital might also have fallen making investment more affordable.