Why does a decrease in the interest rate raise the total amount of investment in a society?
I would think that a decrease in the interest rate would discourage investment and lower total investment. What am I missing?
If the Fed decreases the Prime Rate, it means it’s cheaper for businesses to borrow money to build factories and stuff. It also makes it cheaper for banks to borrow money to lend to other people at a slightly higher rate.
Basically, the cheaper the money is to borrow, the more people are going to use said borrowed money to invest in capital goods, thus increasing the means of production and causing those who invested in said business to make money and get rich.
Would you be more likely to buy a house if the mortgage rates were 5% or 10%?
You are, in all likelihood, using the wrong definition of investment. Economic investment is not the purchase of bonds and securities. Economic investment is expenditures on new goods and services that will be used to facilitate future production. Examples include the purchase of new factories or machinery, increasing inventory stock or residential construction. By decreasing borrowing costs, the cost of investing in these types of things becomes cheaper.
Put another way, the economy does not run on money. It runs on money moving around, being exchanged for goods and services. Lowering the interest rate is “providing liquidity”, that is, greasing the wheels of commerce by making it easier to borrow money.
If I get a $20 bill and put it under my mattress, it might as well not exist at all as far as the economy goes. But, if I spend my $20 on buying a pizza pie and a pitcher of soda for my family… And the pizza store owner then gives that $20 as part of his delivery boy’s pay… And the delivery boy spends the $20 on movie tickets and a tub of popcorn for his date… Etc., etc., NOW things are happening!
On the other hand, an overabundance of liquidity results in inflation. When everyone has money to spend, its relative worth is less. The Master gave one illustration of this principle in his column addressing the question What happened to all the gold Spain got from the New World?, where he replied, at least in part it was a matter of a sharply increasing amount of money (in the form of silver and gold) chasing a relatively fixed output of goods and services, thus bidding up the price.
This is standard economic theory – for sure there are contrarians.
“Investment” is people betting a business will succeed or (for example) a house will increase in value.
Many of these bets are made with borrowed money, on which the investor pays interest. If interest rates are down, the overall cost of the bet is lower, and people are more likely to bet.
The Central Banks do not raise or lower rates.
They set a target rate they would like to see commercial banks lend to each other their reserve balances kept at the Fed. To achieve this target they expand or contract the supply of money. To expand they print up some dollars and exchange it for treasuries and other collateral from banks. More money is floating around the system therefore it is less scarce and cheaper to get i.e. lower rates. They raise the target rate by doing the opposite.
I looked around for a decent graphical model that wasn’t a .pdf or .ppt and this was the best I could find.
Interest rates go up on the left side. Output of the economy is across the bottom, increasing left to right.
The IS line is Investment/Savings
While it’s dangerously close to oversimplifying the LM line is the money supply.
Ignore the BP line for our purposes
If you look to the left there are some mouse over links. Pick the one under Monetary Stimulus - Fixed. When you mouse over that you can see the LM line shifts to the right (the new red LM line) representing an increase in the money supply. The intersection of the IS and LM lines is now lower (as in lower interest rates, demonstrated on the left axis) and shifted to the right or greater investment/savings. We also have a higher output for the economy, as shown by its move along the bottom.
Anyway this is a very simple model to help with the general concept. It can get incredibly complicated from there and many economists think it’s complete bullshit.
No, no, no. You are also using the wrong definition of investment.
I think this may be it. I need to look at my terms more thoroughly. Thanks to all who replied…
Not quite. I am explaining a very basic concept in intuitive terminology.
Carry on.
It works in the security-buying definition also. Let’s say I’ve identified a stock that I think will make me 8% a year (I’m ignoring taxes). If I can borrow money at 3% interest and make 8% with that money, I’d probably do it. If I can only borrow money at 7.5%, I probably wouldn’t take the risk. If I can only borrow money at 10%, I definitely wouldn’t.