The Significance of the Rate of Interest in the Determination of Firms’ Investment Decisions

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Discuss the relevant significance of the rate of interest in the determination of firms’ investment decisions What are the policy implications of this for a government, which wishes to promote economic growth? Alternative Theories of Business Investment Behaviour 4 Keynes on Animal Spirits 8 The concepts entailing the investment decisions made by firms, and the significance of interest rates in the preceding represents a broad as well as complex series of issues, factors, agents, inputs, policies, and other factors that impact upon this area, investments. The policy implications of governments in the preceding affects the outcomes of the circumstantial equation into where these items mesh at differing points in time, and as such represent another determining factor in how investment decisions will thus ultimately be made within this context. This examination shall examine two facets within the foregoing, 

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  1. The alternative theories of investment behaviour, and the competing theories that places differing emphasis on interest rate importance, along with other factors
  2. The connection between investment and economic growth

The preceding will also include brief references to the limits that face governments in managing their economies and theories of interest rate determination to provide a balanced view of this complex subject matter. Alternative Theories of Business Investment Behaviour Interest rate, represents the profit yielded over time as a result of the utilization of financial instruments (Piana, 2002). In terms of companies, interest rates can be determined by a number of factors (Piana, 2002):

  1. The credit worthiness of the organization receiving the loan
  2. The use and aims of the plan being financed, for example, investment, working capital, consumption, with the external variables in terms of the utilization of said funds having an impact upon the interest rate computation.
  3. The number, frequency, risks and amounts of reimbursement actions in connection with the loan
  4. The locale, risks, stability and political situation connected with the end use of the investment.
  5. The corporation’s track record in similar investment instances as well as its position in the overall market relative to its competitors concerning sales, projected strengthens and weaknesses as well as innovations and market penetration

All of the preceding are contingent upon the prevailing global interest rate within the corporation’s home country. The changes represented by interest rate structures are acted upon by reasons that are internal as well as external to financial markets, ass represented by the following (Stapetenand and Subrahmanyam, 1999).

  1. Differing types of interest rates influence and are linked to each other, thus the functioning of financial markets along with their relationships in the international arena represent a good portion of fluctuations in the rates.
  2. The overall economy, as well as the performance, expectations and perspectives of the corporation receiving the loan also plays an important part.

The scope of globalisation thus exerts considerable influence on domestic conditions, and with financial markets being linked on an international basis as well the Central Banks of individual countries, in most instances, increased their co-operation as a result (Piana, 2002). The policy of the Central Banks represents the final determination of the country’s official interest rates, and thus influences business decisions regarding the timing of potential investment decisions. Interest rate increases can be a result of one or more of the following factors (Piana, 2002):

  1. The Central Bank seeking an anti-inflationary policy to restrict the growth of the nominal money supply as well as slow rising discount interest rates.
  2. Central Bank policy of either a revaluation of the currency, and or defending the currency from devaluation.
  3. Attempt by the Treasury in covering its public deficit through the issuance of additional bonds in a market that is basically unwilling to accept more governmental debt.
  4. The ending of an inflationary stage in the country.
  5. A relaxation regarding the need to defend the exchange rate.
  6. A fall in the country’s stock exchange.
  7. A fall in the overall profitability of the country’s major firms.
  8. A fall in the country’s private investment.
  9. A fall in credit consumption.
  10. Upward pressure on the exchange rate.

Policy, and expectations greatly influence interest rates; as a result the relationship with the business cycle is therefore dependent upon decisions that are explicit, as well as subjective judgements on the part of key institutions. For example, if the use of interest rates is mainly employed to tune business cycles, then the rates will fall in recession periods slightly, and then rise on a steady basis when the economy recovers (Piana, 2002). At the end of the period of growth after the recession period, then interest rates will be increased to slow, or brake potential inflationary ramifications (Ranson, 2007). In the instance of inflation, the policy rules change. During a stagnant period, meaning whereby the Gross Domestic Product is depressed as a result of high inflation, interest rates might be high, therefore a counter cycle pattern potentially emerges (Ranson, 2007). Inflation represents a percentage increase in the price levels (Ranson, 2007). Inflation needs to be matched by corresponding, nominal, increases in earning income; otherwise individuals within the economy become poorer. The importance of the preceding in terms of its relationship with business decisions to invest is that they do extensive research into the patterns, and policies of foreign countries, and track extensively the patterns and cycles in their home office, or main business locations, countries. Borrowing, and or building in high interest rates, and or inflationary periods erode the buying power of the funds utilized, and thus increase the investment return period for breakeven substantially. Such is made more of the case when the sums of money being utilised are quite large. Moderate inflation ranges between 5% to 25-30%, dependent upon the historical rates for the country in question, the following examples provide a clearer perspective in order to gauge the business investment significance (Ranson, 2007):

  1. Low Inflation

Between 1 and 2% to 5%

  1. Moderate Inflation

As is the case with most financial and economic areas, the definition of any term can have widely differing meanings dependent upon the country and region under consideration. Thus, moderate inflation is defined as existing between a range of 5% to 25%, with the higher segment of the preceding range representing ‘high inflation’ for some countries.

  1. Extremely High Inflation

This can range anywhere between 50% and 100%, and can also represent an increase in inflation representing anywhere between 30% and 50% annually. Anything hovering within this vicinity is dangerously close to ‘hyperinflation’.

  1. Hyperinflation

This represents the most extreme manifestation of inflation that represents annual price increases representing three-digit percentage points that grows at an accelerated rate. Inflation reduces incomes as well as consumption and savings, and can be attempted to be controlled by Central Banks via a sharp increase in real interest rates (Ranson, 2007). The preceding generally initiates a fall in investment as well as a revaluation of currency. Piana (2002) tells us that the first remedy “… brakes domestic demand …” while the second reduces foreign demand. Higher interest rates postpone business investment as it:

  1. Increases the cost of a company’s investment, thus inducing higher risk in terms of return achievement.
  2. Represents entering an investment at the wrong period and thus inducing risk for shareholders in terms of future stock and bottom line performance, thus impacting stakeholders.
  3. Negatively impacts economic growth, as a result of reduced investment on the part of a number of businesses.
  4. Reduces the formation of new jobs.
  5. Impacts industrial output

In discussing the impacts of investment in terms of interest rates, the preceding refers to both outside investment, meaning the attraction of companies into a country to establish and or expand their operations, as well as domestic companies expanding within their home markets. In the later instance, such, higher interest rates, reduce domestic production and thus competitiveness which can weaken their ability to compete with foreign firms as well as on an export level. In terms of foreign companies, higher interest rates can causes companies to seek locales with more favourable interest rates, thus representing a loss of investment, jobs, wealth creation and related factors. Henderson (2007) advises that economic growth takes place when individuals take resources and re-organise and arrange them in ways whereby they become more valuable. Money represents a key ingredient in the process as it provides the means to obtain more efficient techniques, equipment, processes, affiliations and methods to obtain the preceding objective.

Keynes on Animal Spirits

Beenhakker (1996, p. 30) puts the preceding into perspective regarding publicly traded companies in that the stock price represents, among other things, the company’s projected capacity to earn revenues from new plant, processes, and markets, aspects that factor in the company’s recent, and planned investment(s) in these areas. Kalecki as well as Keynes (Asimakopulos, 1988, p. 147) advise us “…the key element in the determination of the level of economic activity in any short period in a capitalistic economy is the rate of investment that firms have decided to implement … “. Kalecki’s (1971, p. 13) view concentrates on profits, which are directly, and positively intertwined with economic activity, and stated: “Thus capitalists, as a whole, determine their own profits by the extent of their investment and personal consumption. In a way they are ‘masters of their fate’; but how they ‘master’ it is determined by objective factors, so that fluctuations of profits appear after all to be unavoidable” John Maynard Keynes (1973, p. 121) explained the linkage between investment and economic growth as: “…the level of output and employment as a whole depends on the amount of investment. I put it in this way, not because this is the only factor on which aggregate output depends, but because it is usual in a complex system to regard as the causa causans that factor which is most prone to sudden and wide fluctuation. 

More comprehensively, aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital assets, on the propensity to spend and on the social factors which influence the level of the money wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital assets, on the propensity to spend and on the social factors which influence the level of the money wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little …” The relevance of the foregoing is that unless a firm has sufficient savings to finance its investment(s), it seeks outside financing through banks, and thus is subject to interest rates, as explained. In all cases, the binding agent, in terms of interest, economic policy and investment decisions is represented by the human factor. In equating this facet, Keynes refers to ‘animal spirits’, whereby decisions impacting and affecting the future “… cannot depend on strict mathematical expectation …” (Melberg, 2007). Keynes asserts that the foregoing is true “… since the basis for making such calculation does not exist …” as they are based upon projective inputs, and speculation as to how future events might proceed (Melberg, 2007). His, Keynes, “… writings on uncertainty are widely acknowledged by, and indeed have clearly influenced the thinking of many economists …” (Lawson, 1993). Harris and Knopf (1947, p. 50) explain that the cornerstone of the Keynesian system is based upon the rate of interest. 

They advise that “… Keynes was very optimistic concerning the effectiveness of monetary expansion operating through the rate of interest in pulling a country out of the quagmire of deflation …” (Harris and Knopf, 1947, p. 50). In Keynes’ “…General Theory, he stressed the relation of the rate of interest, and marginal efficiency of capital as a determinant of the amount of investment and hence of employment” (Harris and Knopf, 1947, p. 50). In explaining ‘animal spirits’, Harris and Knopf (1947, p. 50-51) tell us that in making calculations, estimates, and projections concerning the probability of future events “An estimate of what an investment will earn five, ten, or twenty years hence is based largely on guesswork, on animal spirits, on adapting estimates to the average estimate, which in turn is based on uninformed guesses”, thus uncertainty represents a deterrent to investment. “ Arestis et al (2002, p. 21) explain “In the Keynesian case there are different types of agents – consumers, workers, producers, renters and entrepreneurs. There is an overlap between these categories. Thus producers and entrepreneurs overlap, as do consumers and workers” Keynes statement on ‘animal spirits’ represents how decision makers focus on the differing agents acting in the economic stage, and the action between these agents that he stated is based upon projections that in reality individuals do not have a basis for making decisions upon (Arestis et al, 2002, p. 21). 

The expectation of entrepreneurs concerning profits that has the probability of a high degree of variance is also subject to the individual interpretations based upon internal equation systems, animal spirits, that are uncertain, and or undefined as the calculations, and projections that are being utilised to make the decisions (Arestis et al, 2002, p. 21). Lawson (1993) does advise however “ …Although the situation as a whole may be characterized by a degree of instability, the fact that agents fall back on convention does, within the wider existing institutional framework, also allow for a significant degree of structural stability to prevail …”. Keller (1983, pp. 1087-1095) tells us that post Keynesians, and institutionalists share the same concepts regarding time, money as well as society. Tymoigne (2003) aids us in summarising the foregoing Keynesian concept: “ … time is historical, it implies that decisions are irreversible and that uncertainty matters and shapes the behaviour of economic actors. This appears notably through the use of money, which permits the transfer of purchasing power from the future to the present (satisfaction of animal spirits) and the transfer of expected purchasing power in a safe form, from the present to the future (liquidity preference)”

Connection Between Investment and Economic Growth

The case for the connection between investment, and economic growth is amply demonstrated by China. The country introduced its first round of economic reforms in 1979, which represented the Central government’s plans to put into place incentives for internal savings, and investment to build the economy (Morrison, 2006). During the period 1960 through 2005, the average annual growth rate of the Chinese economy grew from 5.3% to 10.1%, which economists attribute that much of the foregoing was and is a result of two principle factors (Morrison, 2006), large scale investments, as financed by domestic savings as well as foreign investment, and a rapid growth in productivity In addition, it is also acknowledged that the economic reforms led the country to increased economic efficiency (Morrison, 2006). The preceding is hailed as boosting production output as well as increasing the resources to result in additional investment. The following illustrates the growth in China’s Gross Domestic Product for that period: Table 1 – China’s Average Annual Gross Domestic Product Growth Rates, 1960 – 2005 (Morrison, 2006)

Time Period Average Annual % Growth
1960 – 1978 (pre-reform) 5.3
1979 – 2005 (post reform) 9.7
1990 3.8
1991 9.3
1992 14.2
1993 14.0
1994 13.1
1995 10.9
1996 10.0
1997 9.3
1998 7.8
1999 7.6
2000 8.4
2001 8.3
2002 9.1
2003 10.0
2004 10.1
2005 9.8

The case for investment, and economic growth is further found in China’s high savings rate. In 1979 the country’s domestic savings as represented by a percentage of GDP was 32%, which was primarily a result of state-owned enterprises (Morrison, 2006). The preceding was used by the government to increase domestic investment, and through economic reforms household savings underwent substantial growth, and thus now account for 50% of all domestic savings (Morrison, 2006). The reforms have aided the yearly increase in savings to the point where savings, as a percentage of Gross Domestic Product, has risen to 49% in 2004, making the foregoing the highest in the world (Morrison, 2006). The example of China has been used to illustrate the ties between interest rates, investment, and economic growth. It is by no means an isolated case, as evidenced by the growth of the Asian Tigers, and other examples. In equating the success of China, as well as the Asian Tigers and other high growth rates, it is important to establish comparative examples. Developed economies, the steady growth rate model indicates total savings, as represented by the formula (Kaplan, 1999): Total Savings = Private Savings + Public Savings + Net Foreign Savings To explain why less developed countries have productive capacity growth rates representing double, triple and greater on an annual basis, as compared to developed economies that range between 2% to 5% per year, one needs to look at the Solow Model for the difference in potential output growth (Kaplan, 1999). Mankiw (2007, p. 186) advises that the purpose of macroeconomic analysis represents the explanation of why the income of nations grows, and why the economies of some countries grow faster than other countries. In explaining the preceding, Mankiw (2007, p. 186) discusses the inputs of:

  • production,
  • capital,
  • labour,
  • the country’s economic output, and thus its total income. 

He explains that the differences in terms of income are result of differences in labour, capital as well as technology (Mankiw, 2007, p. 186). The Solow growth model illustrates how savings, along with population growth as well as technological progress have a direct effect upon a country’s economic output, and thus its growth (Mankiw, 2007, pp. 186-187). Savings represent the key determinant in investment as plentiful money aids in lowering interest rates in conjunction with the Central Bank, and governmental policy, taking into account other factors. Solow’s model explains that less developed countries in almost all instances have lower living standards, along with smaller economies, less capital as well as lower capital ratios than developed nations (Kaplan, 1999). As a result, lesser-developed nations do not need to devote a large portion of their savings, and investments to replacing depreciated plant, equipment, and other assets therefore leaving more for new asset development. In addition, the lowered costs of doing business, purchase, and or the leasing of land for plant, and or offices as well as the lowered costs of labour, related business expenditures, and in the case of China and or India, their huge domestic markets, makes investment a growth proposition (Kaplan, 1999). The preceding eventually balances out as LDC’s achieve a comparable internal market, and industrial development, falling into a ‘steady state rate of growth’ that identifies developed economies. Mankiw et al (1992, pp. 407-437 in an empirical note advises that the reservations in the Solow model that he raised concerning if balanced growth represents the norm, states the neoclassical growth model is widely accepted as it generates explanations for economies nearing the steady state growth rate (Blankenau and Cassou, 2004). 

The foregoing, ‘steady state economy’ is defined as one having a relatively stable as well as mildly fluctuating population and per capita consumption (Czech and Caly, 2004). Kumar (2007) sums up the preceding in stating that investment represents the manner in which countries as well as companies utilise financial assets to create wealth through investment in plant, equipment, technologies and market locations. The significance of interest rates in the determination of the investment decisions of business firms represents a cost analysis factor based upon the utilisation of a financial asset to yield an agreed upon, and a rate of overall return that compensates for the use of money in an environment that has acceptable risk. Such is subject to variable that are outside of the control of the company in that is depends upon the state of international economics, monetary policies, consumption patterns, future market stability, and savings. This entire complex series of interactions is dependent upon the actions of individuals, most of whom are working towards their own firm and or institutional self interests to maximise their returns. Interest rates represent the binding foundation of the overall calculation starting point in that future projections as to the impact of the anticipated use of funds for a specific purpose is dependent upon future factors and forecasts that may or may not accurately predict those events. The preceding is referred to as ‘animal spirits’ by Keynes, representing that individualized nature of the internal decision processes, and the uncertainty of events, which are used in arriving at the determinations. Governmental policies are reactionary in terms of addressing shifts in economic trends, both internal and externally that impact upon their countries. In addition, immediate, short-term, intermediate and long term policies enacted by governments on an individual and collective basis influence these events, thus forcing further in-phase adjustments to achieve outcomes.

 These are all predicative facets responding to the foregoing that seek to moderate present and future events into more favourable outcomes within individual economies. Central Bank actions in consort with the preceding are inputs contributing to the equation to attempt to create an internal economic environment that is conducive to growth, and market stability to present instances whereby the longer term prospects point to a business condition companies seek to basis investment decision in and upon. The foundation, as stated, rests in interest rates as well as future economic growth prospects that are representative of market conditions, which will yield anticipated returns. As Keynes aptly stated, the entire equation of uncertainty underpins the process. Firms do have a degree of control in that their past fiscal performance, if positive, aids in their being offered interest on more favorable terms, however, such is still subject to the vicissitudes of the overall international and national environment that consists of decisions made individually and in consort regarding economic variables.

References:

  1. Arestis, P., Desai, M., Dow, S. (2002) Methodology, Microeconomics and Keynes: Essays in Honour of Victoria Chick. Vol. 2. Rutledge Publishers, London, United Kingdom Asimakopulos, 
  2. A. (1988) Investment, Employment and Income Distribution. Westview Press, Boulder, CO, United States Beenhakker, H. (1996) Investment Decision Making in the Private and Public Sectors. Quorum Books, Westport CT., United States Blankenau, W., Cassou, S. (2004) Labor Market Trends with Balanced Growth. Kansas State University Czech, B., Daly, H. (2004) 
  3. In My Opinion: The steady state economy – what it is, entails, and controls. Center for the Advancement of the Steady State Economy, Arlington, VA, United States Harris, S., Knopf, A. (1947) The New Economics: Keynes’ Influence on Theory and Public Policy. Alfred A. Knopf Publishers, New York, New York, United States Henderson, D. (2007) The Concise Encyclopaedia of Economics. Liberty Fund. In Romer, P. (2007) Economic Growth. Retrieved on 24 July 2007 from https://www.stanford.edu/~promer/EconomicGrowth.pdf 
  4. Kalecki, M (1971) Selected Essays on the Dynamics of the Capitalist Economy: 1933-1970. Cambridge University Press, Cambridge, MA, United States Kaplan, J. (1999) Applications of the Solow Model. Retrieved on 25 July 2007 from https://www.colorado.edu/Economics/courses/econ2020/section15/section15-main.html 
  5. Keynes, J. (1973) The General Theory and After: Part II Defense and Development. Volume XIV of the Collected Writings, Macmillan for the Royal Economic Society, London, United Kingdom Kumar, A. (2007) Economic Letter – Insights from the Federal Reserve Bank of Dallas. Retrieved on 25 July 2007 from https://dallasfed.org/research/eclett/2007/el0701.html 
  6. Lawson, T. (1993) Keynes and Conventions. Vol. 51. Review of Social Economy. Mankiw, G. (2007) Macroeconomics. Worth Publishers, New York, N.Y., United States Melberg, H. (2007) A note on Keynes Animal Spirits. Retrieved on 25 July 2007 from https://www.geocities.com/hmelberg/papers/990214.htm 
  7. Morrison, W. (2006) China’s Economic Conditions. 12 January 2006. CRS Issue Brief for Congress, Congressional research Service, The Library of Congress, Washington, D.C., United States Piana, V. (2002) Interest Rates. Retrieved on 23 July 2007 from https://www.economicswebinstitute.org/glossary/interest.htm Ranson, D. (2007) Inflation. Retrieved on 25 July 2007 from https://www.econlib.org/library/Enc/Inflation.html 
  8. Stapletenand, R., Subrahmanyam, M. (1999) The Term Structure of Interest-Rate Futures Prices. Workshop on Financial Engineering and Risk Management, European Institute ofr Advanced Studies in Management, Brussels, Belgium Timoigne, E. (2003) Keynes and Commons on Money. Vol. 37. Journal of Economic Issues
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