Gross investment refers to expenditures by firms on capital goods and equipment. To encourage greater business investment and stimulate economic growth, central banks can lower interest rates through expansionary monetary policy. This makes it less expensive for firms to borrow money to invest in new facilities and equipment. Therefore, to increase gross investment, central banks can lower the interest rate to motivate businesses to invest more. The interest rate affects investment through several channels based on cost of capital, expectations and asset prices. By understanding how interest rates impact investment, central banks can calibrate rate changes to achieve their macroeconomic objectives.
Lower interest rate reduces cost of capital
The cost of capital refers to the required return necessary for a project to be financially viable. A lower interest rate reduces a firm’s cost of capital in several ways. First, it directly lowers the cost of debt financing since interest expenses are reduced. Second, a lower interest rate increases equity prices and lowers the equity risk premium, thereby reducing the cost of equity capital. With lower capital costs, more projects become profitable and investment in new facilities and equipment rises. Empirical evidence shows that investment is negatively correlated with interest rates.
Lower interest rate raises business optimism
Business expectations regarding future growth prospects are a key driver of investment. Lower interest rates can stimulate optimism and raise profit expectations, motivating firms to expand capacity. When interest rates decline, businesses anticipate stronger economic growth and consumer demand. This results in more investment spending today to meet expected future sales.
Lower interest rate boosts asset prices
Lower interest rates increase the prices of financial assets such as stocks and real estate. The resulting wealth effect spurs consumption and economic growth. Higher asset values also directly encourage investment by making it easier for firms to borrow against collateral. Additionally, rising equity prices lower the cost of equity financing. Therefore, lower interest rates boost investment by increasing asset prices.
In summary, lowering interest rates can increase business investment through reducing the cost of capital, raising economic growth expectations, and boosting asset prices. By lowering interest rates, central banks give incentives for firms to invest in more projects and expand productive capacity. Understanding the interest rate transmission mechanism allows policymakers to effectively use monetary policy tools to achieve macroeconomic goals like stimulating investment and economic growth.