Analyzing the Influence of Interest Rates on Business Investment

This report examines the impact of interest rates on business investment in the Australian economy. It begins by discussing the current economic climate, including low government spending and low economic growth, and explores the common belief that lower interest rates promote economic growth by encouraging investment. The analysis delves into the effects of lower interest rates on business investment, considering arguments from various economists, such as the impact on capital acquisition, savings, and money supply. The report uses a graphical representation to illustrate the relationship between interest rates and business investment. Furthermore, the report analyzes the effects of increased business investment on aggregate demand, real GDP, and the price level, providing a comprehensive understanding of the macroeconomic implications. The conclusion emphasizes the importance of government policy decisions and their impact on the economy.

Running Head: Australian Business Investment
How Business Investment is influenced by Interest Rate
By (Name)
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How Business Investment is influenced by Interest Rate
Introduction
Consumers’ confidence has already been undermined by the low level of government
spending. The cut in government spending is a contractionary policy and thus not good for an
economy like Australia that is struggling with the issue of low economic growth. The Australian
RBA’s cash rate has been lowered to a level that is too low; despite this reduction, the economic
growth has been low. It is therefore not certain whether a further interest rate cut would have a
significant positive impact on the economic growth. Generally, economists believe that low
interest rate is a major promoter of economic growth. It promotes economic growth in that it
encourages investors to invest more on businesses by discouraging them from saving. All the
capital that the investors fail to save is invested. On the contrary, the impact of low interest rate
on the Australian business investment has not been attractive. This paper will consider all the
arguments posed by different economists and weigh the possibility of business investment rising
or remaining unchanged after a further drop in the cash rate. It will also determine how high
level of business investment impacts the aggregate demand, the real GDP and Price level.
Analysis
The lower cash rate will definitely result in increased business investment if not
accompanied by other economic issues. The discouraged investors will be attracted to invest by
the low interest rate. Maguire (2017) noted that the acquisition of capital is dependent on the
interest rate offered; businesses would find it to repay their loans when the rates are lower.
According to Pettinger (2016), lower interest rate discourages savings since the returns gained
from saving declines and thus consumers prefers spending over saving; part of this spending
goes to investment. An interest rate of close to zero as is the case for Australia makes the interest
income from savings to be close to zero; this may offset the positive effects of the reduction in
interest rate because people such as savers who rely heavily on saving will have no income to
make demand. However, this would make such savers to quit saving and withdraw their bank
deposits and invest in risky investments such as stocks (Madura (2014).
There is plenty of money supply in the economy whenever the interest rate is lower. This
creates a need for the banks to lend more; they can only do this by in turn lowering their interest
rate to make the loans more attractive such that the demand for the loan goes up (Duff, 2017).
The low interest rate causes the loan borrowing costs to fall. Thus, Financing Manufacturing,

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operations and distribution of goods and services become cheaper. This in turn makes the price
on goods and services to fall. Consumers therefore benefit from these low prices and their
demand rises; a higher demand subsequently stimulates investment in that there is an expanded
market for the produced goods. Households and investors take this chance to borrow loans to
repay their debts; thus there is more funds available for investment.
Fig: The impact of cutting interest rate on Business investment
Interest
Rate
r1
r2
BI1 BI2 Business Investment
The initial interest rate level is r1 and the business investment at this interest rate level is BI1. A
reduction in the interest rate from r1 to r2 results in the business investment rising from BI1 to BI2
(Madura, 2012). The lower cost of using capital increases the number of business opportunities
that need to be funded.
The argument here is that consumers and investor’s spending has already been
discouraged; the discouragement has resulted from a reduction in money in the economy after
the government reduced it spending. However, an expansionary monetary policy will have a
similar impact to a high level of government spending. Thus a low interest rate will increase the
money in the Australian economy and the consumer and investors’ confidence will be restored.
Duff also noted that interest cycles are important for businesses. They time when the interest rate
are lower to expand their businesses. Business expansion results in more people being employed
and higher wages are offered, this stimulates the economy’s demand. Their increased spending
will stimulate business investment. The low interest rate will also lead to a decline in the

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Australian exchange rate which will make its export more competitive and thus a need to
increase production. Consumers will take the advantage of the low rate to invest in assets that
would increase their wealth. According to Bagus (2015), lower interest rate makes some projects
to be profitable that would otherwise have been unprofitable.
The Impact of a Rise in Business Investment on the Aggregate Demand
Assuming that the reduction in interest rate has succeeded in raising the business
investment, it is expected that this will subsequently influence the aggregate demand. An
increase in business investment causes the aggregate demand to rise; this is because business
investment is one of the components of the aggregate demand. The other components include;
consumption, government spending and the net export. The equation for the aggregate demand is
given by; AD=C+I +G+ ( X – M ) where (X – M) is the net export (Mankiw, 2016). Any addition
of the right hand side components is reflected on the left hand side component. The increase in
aggregate demand causes a right ward shift of the Aggregate demand curve (Sexton, 2015). To
show the changes in the aggregate demand, a graph of the general price level against the real
GDP is plotted as follows;
Fig: The Shifting of the Aggregate demand curve to the right
Price Level LRAS
SRAS
P2 E2
E1
P1
AD1 AD2
Y1 Y2 Real GDP
LRAS is the long run aggregate supply curve whereas SRAS is the short run aggregate
supply curve. The graph above shows the impact of a rise in business investment from a
reduction in interest rate. The impacts rendered above is on three components; one is the demand

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curve, second is the real GDP, and finally is the price level. The analysis starts from an initial
equilibrium level of aggregate demand and Supply. The aggregate demand curves are downward
sloping, SRAS upward sloping and the LRAS is vertical. The vertical supply curve represents the
maximum production level of the economy. The equilibrium level to start with is point E1 where
the price level is P1, the real GDP level is Y1, the Aggregate demand curve is AD1 and the supply
curve is SRAS. Increase investment shifts the AD1 curve to AD2. This rightward shift forms a
new equilibrium E2. The new equilibrium E2 is at a higher level and is characterized by a higher
real GDP level Y2 and a higher price level P2 (Khanacademy.org, 2017). Thus, a lower interest
rate will help in the recovery of the Australian economy.
Conclusion
It is not effective for the government to lower its spending when its economy is not
performing well. The best time to consider lowering the spending is when the economy has
picked and the aggregate demand is higher. The government should choose its policies wisely to
avoid hurting the economy. Lower interest rate in Australia may will stimulate the business
investment but not that much. Any increase in the business investment no matter how small will
add to the aggregate demand and the real GDP will rise causing a rise in price.

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