The relationship between interest rate and investment

Higher interest rates reduce investment because higher rates increase the cost of borrowing, and require investment to get a higher rate of return to be profitable, because the concept of investment lies in increasing the stock of capital. Marginal efficiency of capital (MEC) determines the rate of return on an investment project, and specifically refers to the annual percentage return (output) achieved by the last additional unit of capital.

For example, if the marginal efficiency of capital is 5%, and interest rates are 4%, then you must borrow at 4% to get an expected increase in output of 5%, i.e. the effective profit margin is 1%, but if interest rates rise from 5 % to 7%, there will be a decrease in the amount of investment from 100% to 80%.

Investment is discouraged when its cost increases, when interest rates are raised, borrowing money from the bank becomes more expensive, saving money in the bank leads to a higher rate of return, and using savings becomes the opportunity cost of lower interest payments, but raising interest rates increases the need for companies To get a better rate of return to justify the cost of borrowing or using the savings.

Real interest rates and investment

Companies are very interested in the real interest rate, and take it into account before starting any new investment, as it is known as the nominal interest rate or inflation, as both of them play a major role in the investment process.

For example, if inflation is 10%, and nominal interest rates are 9%, then the real interest rates are negative, which means that borrowing money is more desirable; Because inflation will make it easier to pay it off, but when inflation is 4% and nominal interest rates are 6%, the real interest rate is 2%.

Why investors are so interested in the interest rate

The interest rate or rate is the amount that the lender charges the borrower, which is a percentage of the principal, i.e. the amount borrowed, and is usually monitored on the loan on an annual basis known as the annual percentage rate (APR).

Interest rates are of great interest to investors because of their direct impact on the returns they earn from their investments, such as bonds, in addition to their direct and indirect impact on the company’s net profits, which affects investors’ returns and stock prices, as well as having a significant impact on consumer behavior. Or market demand, company profits, and stock prices.

Other factors affecting the increase in investment

Investment is affected by many factors, the following are mentioned:

  • Economic growth.
  • Banks willingness to lend.
  • Consumption.
  • Technology case.
  • Wage costs.
  • Inflation.
  • Government policy.

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