Question

What is the Investment element in Aggregate Demand? What role does the interest rate play in determining the level of Investment?

Answer 1

Aggregate demand means total goods and services demanded in the economy. There are four elements of aggregate demand consumption, investment, government spendings and net exports. All the elements are important in determining the aggregate demand. Therefore investment also plays major role in determining aggregate demand. Here investment means spending done on capital goods by businesses not households. Increase in the level of investment shifts demand curve towards right. Increase in investement means businesses are purchasing more capital goods for production purpose. Therefore demand for capital goods increases. Investment also increases production which therefore increases the gdp the country.

Interest rate is the most important factor which normally determines the level of investment. Businesses take loan from commercial banks at a certain interest for investment in capital goods or to expand their business. When interest rates are lower it becomes easy for businesses to borrow because they will have to pay less as interest that is why lower rates encourage them to borrow and invest. Sometimes they are more prone to take risks because of lower rates.

On the other hand if interest rates are higher they will pay more as interest and it discourages them to take loan and shift their decision for some time. Therefore level of investment in the economy decreases which shifts demand curve towards right. But it is argued that lower interest rates reduces the savings because people find investments more profitable than saving in banks at lower rates.