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Interest Rates: The Cost of Money

The rate of interest can be an important factor in determining whether an investment will be profitable. A project that does not appear profitable when the interest rate is 20 percent, for example, may be attractive if the interest rate drops to 15 percent or 12 percent. To illustrate, suppose that you can purchase a soft-drink vending machine (which has a useful life of one year) for $1,000 and can borrow the money at 20 percent interest. Assume, also, that you expect to sell 5,000 cans of soft drink a year at 60(2 a can and plan to pay 361/2(2

for each can you buy. Would your investment be profitable? A few calculations show that it wouldn't be.

According to these calculations, you could expect to lose $25 on your investment if you had to pay 20 percent interest to borrow the money. So, of course, you wouldn't make the investment under those conditions. But if the interest rate declined to 15 percent, the cost of borrowing $1,000 for a year would drop to $150, and the investment would earn a profit of $25. If the interest rate declined further, the profit would be even greater. The point we are making is that lower interest rates encourage businesses to undertake investments that would be unattractive at higher rates. Thus, we have a negative, or inverse, relationship between the rate of interest and the level of investment spending; the lower the interest rate, the higher the level of investment spending. This relationship is illustrated in Exh. 4.

Expectations about Revenues and Costs

Although the interest rate influences investment spending plans, it should be clear from our example that it is not the only factor to take into consideration. Businesses will continue to borrow and invest in spite of high interest rates if they are optimistic about future revenues (and costs) and the likelihood of earning a profit. For example, even a 20 or 25 percent interest rate would not discourage you from investing in the vending machine if you were convinced that you could sell 6,000 cans of the soft drink a year. On the other hand, an interest rate as low as 6 percent would be prohibitive if you were forecasting sales of only 4,500 cans. (Take the time to make some calculations and convince yourself of these conclusions.) In short, it is not interest rates themselves that determine the attractiveness of investment projects and the level of investment spending in the economy but rather the interaction of interest rates and expectations about future revenues and costs.

EXHIBIT 4. Investment and the Rate of Interest

Investment and the Rate of Interest

The Instability of Investment

The preceding discussion shows why investment spending is much less stable than consumption spending. There are several reasons. First, the interest rate tends to change over time, and these changes cause businesses to alter their investment plans.

Second, businesses' expectations are quite volatile, or changeable. They are influenced by everything from current economic conditions to headlines in the newspaper. If a wave of optimism hits the country, planned investment may skyrocket. When pessimism strikes, investment plunges.

A third source of instability is the simple fact that plans to invest can be postponed. A business may want to build a more modern production plant to improve its competitive position. But if economic conditions suggest that this may not be the best time to build, the business can decide to make the old plant last a little longer.

Finally, investment opportunities occur irregularly, in spurts. New products and new production processes provide businesses with investment opportunities, but these developments do not occur in predictable patterns. A business may encounter several profitable investment opportunities one year and none the next.

Changing interest rates, the volatility of expectations, the ability to postpone investment spending, and the ups and downs of investment opportunities all lead to fluctuations and instability in the level of investment spending. Because investment spending accounts for more than 15 percent of the GDP, these changes can have a major impact on total output and employment in the economy. We'll have more to say about that impact later in this chapter.

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