Saturday, January 11, 2014

Business Investment Decisions Are Insensitive To Changes In Interest Rates

The investment demand curve is one of the fundamental tenets in economics.  It suggests that CFO's use the interest rate as their hurdle rate in making investment decisions.  That is, they will make an investment when the expected rate of return is greater than the interest rate.  Consequently, lower interest rates will stimulate investment demand.  The Federal Reserve Board researched this question by surveying CFO's.  They found that investment demand was very insensitive to changes in the interest rate.  The results of their survey are confirmed by the current lack on investment during a period of historically low interest rates.  Keynes would not be surprised by this result.  He argued that investment decisions are motivated primarily by the expectation of high demand for a product or service. 

Interest rates do play a powerful role in the real estate market.  They determine the affordability of housing by influencing the cost of a mortgage.  Federal Reserve policies have been effectively employed to stimulate or weaken demand for housing.  Since residential investment has a substantial effect on aggregate demand, it has been a critical factor in managing economic growth and inflation.

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