If you have found yourself diving into the world of investment, you may get a little confused with some of the many details involved in the process. One major part that we find many beginners struggle to wrap their minds around is investment interest rates, as in what they actually are and how they work. This is why we have put together a guide on the best way to understand investment interest rates to help you get started. So, whether you are interested in consumer or TMT investments, here you will find the best information you need to start the process of understanding.
Why are Investment Interest Rates Important?
Investment interest rates are important to understand as they reflect on what you should invest in and how much. Typically, higher interest rates have been known to reduce investment, this is because higher rates increase the cost of borrowing and therefore require investment to have a higher rate of return to be profitable.
For example, if the interest rate rises from 5% to 7%, we will in return see a fall in the quantity of investment from 100 to 80. When interest rates are increased, it will tend to discourage investment because investment has a higher opportunity cost. It is good to remember that it is more expensive to borrow money from a bank when there are higher interest rates in place. Similarly, saving money in a bank gives a higher rate of return, and therefore, uses savings to finance investment provides an opportunity cost of lower interest payments.
If interest rates are raised, then firms will need to gain a better rate of return in order to justify the cost of borrowing or using savings. For another example, if interest rates were 7%, then any investment project would need an expected rate of return of at least greater than 7%. But this would mean that less investment would occur.
Understanding the Elasticity of Demand for Investment
Of course, interest rates are one very important determinant of investment, although this is not the only factor that you should consider. Other factors to consider include investor confidence, economic growth, the willingness of banks to lend, accelerator theory, and the state of technology. Take for example the position of a liquidity trap in which lower interest rates may have little effect on boosting levels of investment. From this, the demand for investment becomes very interest inelastic.
Other Factors that Determine Investment
Apart from interest rates, there are several other factors that determine investment, and these include:
- Investor Confidence
- Economic Growth – It is suggested that investment is influenced by rates of change in economic growth, and signs of economic recovery will lead to strong growth in investment.
Availability of Finance – If banks are willing to lend then investment will be stronger, but at the minute in a credit crunch, banks may cut back on lending and firms are unable to invest.
