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Let’s say that you are in investor thinking of investing in let’s say
cookies. The rate of return of your investment is 5%. So, now suppose
you have to borrow money to finance this investment. If the interest rate
is 4%, that means that the rate of return on your investment is higher
than the interest rate. Let’s say you get money because you
investment is profitable. Now, let’s see what happens if the interest
rate is 6% instead. In that case even though you earn 5%, the higher
interest rate which is higher than the rate of return actually causes
you to lose money instead of earn money. Then you will find that the
project is unprofitable. So, now suppose you don’t have to borrow
money but you have a stock of cash. Usually companies call this retained
profit because it is left over profit from previous years. You don’t have
to pay interest on this money but again you have two choices: you either
invest the money in cookies or you can save it in the bank. Saving in
the bank gives you an interest. Hence, if the interest rate is 4%, you
will invest it because saving it earns you less money than investing.
However, if the interest rate is 6%, you will rather save your money
and not invest in cookies. Hence, you can see that if I increase the
interest rates, there will be less investments because you will have to
find even more profitable projects to invest it. So, let’s say that
there are 100 projects. Out of these there are only 50 that can earn you
at least 5% rate of return. When I increase the interest rate to 6%, then
the 5% rate of return projects are no longer profitable. So, you will have
to move to projects with at least 6% rate of return and that’s only
probably around 30 projects. Hence, when I increase interest rate, the
number of profitable projects decreases and this also decreases investment
because there will be less projects in which investors can throw their
money. There is a formal theory to describe this. It is called the
Marginal Efficiency of Investment. On the Y axis we plot the rate of
return. On the X axis we plot the amount of investment. So, let’s say
there is a 10% rate of return. There is only one profitable project for
that and 9% has 2, 8% 3 and so on and so forth until at 1% there are
10 projects. Now, since the rate of return always has to be more than
or equal to the interest rate because you will only invest in profitable
projects, then let’s say the interest rate is at 5%, you will only invest
in projects that earn you 5% or more. Hence, you will only invest in 6
projects. Let’s say that the interest rate is at 3%. Then you will invest
in 8 projects. Hence, the Y axis also shows the interest rate. This
graph basically shows the relationship between interest rates and the
amount of projects which is formally called the amount of investment.
Hence, when interest rates increase, the amount of investments
drops. When interest rates decrease, the amount of investment increases.