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Simran (Student) February 27 2017
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.
- 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.
- 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.