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Ceterus paribus, how would an overall increase in interest rates affect a nations' investment levels? Explain...

Ceterus paribus, how would an overall increase in interest rates affect a nations' investment levels? Explain why this is the case. Could this result further have an impact on productivity and GDP? Why, or why not? Explain all responses.

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Answer #1

Yes, an overall increase in interest rates affect the nations investment levels because investment is the function of interest rate i.e I(r). It shares an inverse relation with interest rate that is if interest rate increases the investment falls. At higher interest rate, the cost of borrowing becomes expensive not only this the returns must be higher for investors to gain profit.

The marginal efficiency of capital states the return to investment. So as interest rate rises from r1 to r0, the investment decreases from I1 to I0.

Yes, this further reduces the GDP. Due to a decrease in investment, the Investment-Saving (IS) decreases towards left. Hence as we can see from the diagram below, the output shifts leftwards from Y0 to Y1.

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