Question

In economic theory, firms decide to invest in new capital equipment by comparing the expected profits from the equipment with the cost of borrowing. A lower interest rate has which of the following effects?

Group of answer choices

- It reduces the cost of borrowing, so raises I in Aggregate Demand.

- It reduces the cost of borrowing and so reduces I in Aggregate Demand.

- It raises expected profitability.

- It leads to a lower government budget deficit.

Answer 1

Ans: A lower interest rate has the following effects

• It reduces the cost of borrowing, so raises I in Aggregate Demand
• It raises expected profitability

A decrease in the interest rate implies that it is cheaper to borrow at that period of time. When the cost of borrowing is cheaper, consumers and businesses take out loans to finance and increased spending and investment. The increased spending and investment will raise the Aggregate demand and thereby enhances economic growth. The Aggregate Demand function being AD= C + I G+(X-M), a lower interest rate increases C, I and (X-M)

A decrease in interest rate increases the profitability of banks. Lower interest rates lead the banks to shift from net interest incomes to non-interest revenue which includes fee-based and other trading activities. This interest decline boosts asset valuation that increases bank profitability