Business Investment in Interest Rate †Free Samples to Students

Question: Discuss about the Business Investment in Interest Rate. Answer: 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 RBAs 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 possib ility 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. 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 (M adura (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, 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. 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 investors 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 economys demand. Their increased spending will stimulate business investment. The low interest rate will also lead to a decline in the 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;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; 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 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.or g, 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. Bibliography Bagus, P. (2015). In defense of deflation. Cham: Springer. Duff, V. (2017). How Do Interest Rates Affect Businesses? [Online] Smallbusiness.chron.com. Available at: https://smallbusiness.chron.com/interest-rates-affect-businesses-67152.html [Accessed 11 Oct. 2017]. Gwartney, D., Stroup, R., Sobel, S., Macpherson, A. (2016). Macroeconomics: private and public choice. Boston, Massachusetts: Cengage Learning. Khanacademy.org (2017). Shifts in aggregate demand. [Online] Khan Academy. Available at: https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/aggregate-supply-demand-tut/a/shifts-in-aggregate-demand-cnx [Accessed 12 Oct. 2017]. Madura, J. (2012). International financial management. Mason, OH, South-Western: Cengage Learning. Madura, J. (2014). Financial Markets and Institutions. 11th ed. Cengage Learning. Maguire, A. (2017). How Interest Rates Affect Your Small Business. [Online] QuickBooks. Available at: https://quickbooks.intuit.com/r/financial-management/how-do-interest-rates-affect-your-small-business/ [Accessed 12 Oct. 2017]. Mankiw, G. (2016). Brief principles of macroeconomics. Boston MA: Cengage learning. Pettinger, T. (2016). Effect of lower interest rates. [Online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-rates/ [Accessed 11 Oct. 2017]. Sexton, R. (2015). Exploring Economics. 7th ed. 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