Comment on whether an increase in the rate of interest would reduce investment.

This question can be split up into 2 parts. What it is asking for firstly is an outline of what theory says should happen. As the question starts with the word comment, the second part will involve some evalutation.

Theory:

• An increase in the interest rate is an example of contractionary monetary policy.
  
• It will increase a firm's cost of borrowing, therefore decreasig investment, and increase incentives to save.
  
• As the cost of borrowing increases, this increases the opportunity cost of investment as the extra money could have been spent on something else.
  
  Evaluation:
  
• It depends on the size of the change ~ if the change is only small then firms may ignore the increased opportunity cost and go ahead with investment
  
• It depends on what the rate was in the first place ~ if the rate was already very low then even with an increase in the interest rate, the cost of borrowing may remain low and investment occur.
  
• If firms are optimistic about future profits they may choose to invest anyway.
  
• *The REAL inerest rate may have fallen ~ if the increase in interest rate is met by a greater increase in inflation, the REAL cost of borrowing will fall and firms may invest more.
  
  *more complex point.
  
  In this question the evaluation is key to achieving the highest marks.