Every investment involves taking risks. Though the degree of risk vary; businesses, entrepreneurs, and capital owners will require a return on their investment in order to cover this risk, and earn a reward. So let us take a look at some of the main determinants for investing In An Economy.
Interest rates: Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic growth. Investment is inversely related to interest rates, which are the cost of borrowing and the reward to lending. Investment is also inversely related to interest rates for two main reasons.
Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a rise in interest rates increases the return on funds deposited in an interest-bearing account, or from making a loan, which reduces the attractiveness of investment relative to lending. Hence, investment decisions may be postponed until interest rates return to lower levels.
Secondly, if interest rates rise, firms may anticipate that consumers will reduce their spending, and the benefit of investing will be lost.
If interest rates are increased then it will tend to discourage investment because investment has a higher opportunity cost because:
- 1. With higher rates, it is more expensive to borrow money from a bank.
- 2. Saving money in a bank gives a higher rate of return. Therefore, using savings to finance investment has an opportunity cost of lower interest payments.
If interest rates raised, firms will need to gain a better rate of return to justify the cost of borrowing/using savings.
Investing to expand requires that consumers at least maintain their current spending. Therefore, a predicted fall is likely to discourage firms from investing and force them to postpone their investment decisions. Inflation and interest rates are often linked and frequently referenced in macroeconomics. In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates.
For instance, if interest rates are low, students, governments and business can borrow the money they need more cheaply.
Interest rates are one important determinant of investment. However, it is not the only factor, other factors include investor confidence, economic growth, the willingness of banks to lend, accelerator theory, and state of technology.
Investment in education, infrastructure or business expansion takes money to accomplish. Suppose you have $1000 today that you willing to lend for one year at an annual interest rate of 5 percent. At the end of the year, you will get back your $1000 plus $5 interest (0.05 × 1000), for a total of $1050. The general relationship is:
Money Today (1 + interest rate) = Money Next Year
Corporation tax: Firms pay corporation tax on their profits, so a reduction in tax increases the profits they retain after tax is paid, and this acts as an incentive to invest. In 2009, the rate for small businesses was 21%, and the main rate for profits over £1.5m was 28%. The evidence on investment behavior is fairly clear. When companies have more “free cash” at hand, they tend to invest more, and this effect is distinct from any effect of the tax cut on expected rates of return.
Small increases to the corporate tax rate may affect a typical entrepreneur’s decisions but will not deter him from doing business.
The cuts in corporate tax rates raise the after-tax return on investment and lower the cost of corporate investment. They should lead to more capital investment, which leads to productivity and wage growth. The beneficial effects of the increased investment, however, take time. Investment projects take time to complete and will be spread out over time. Only when those investments are completed, and workers adjust to them, will productivity and wages increase.
The level of savings: Household and corporate savings provides a flow of funds into the financial sector, which means that funds are available for investment. Increased saving may reduce interest rates and stimulate corporate borrowing and investment.
Small changes in household income and spending can trigger much larger changes in investment. This is because firms often expect new sales and orders to be sustained into the long run, and purchase larger quantities of capital goods than they need in the short run.
Because investment is a high-risk activity, general expectations about the future will influence a firm’s investment appraisal and eventual decision-making. Any indication of a downturn in the economy, a possible change of government, war or a rise in oil or other commodity prices may reduce the expected benefit or increase the expected cost of investment.
In addition, machinery is generally indivisible which means it cannot be broken into small amounts and bought separately. Even small increases in demand can trigger the need to buy complete new machines or build entirely new factories and premises, even though the increase in demand may be relatively small.
The combined effect of these two principles creates what is called the accelerator effect. For example, if in a given year national income rises by £20b, and investment rises by £40b, the value of the accelerator is 2.