Interest rates and planned capital investment: 

The Keynesian theory of investment places emphasis on the importance of interest rates in investment decisions. But other factors also enter into the model - not least the expected profitability of an investment project.

Changes in interest rates should have an effect on the level of planned investment undertaken by private sector businesses in the economy.

A fall in interest rates should decrease the cost of investment relative to the potential yield and as result planned capital investment projects on the margin may become worthwhile. A firm will only invest if the discounted yield exceeds the cost of the project.

The inverse relationship between investment and the rate of interest can be shown in a diagram (see below). The relationship between the two variables is represented by the marginal efficiency of capital investment (MEC) curve. A fall in the rate of interest from R₁ to R₂ causes an expansion of planned investment.

Shifts in the marginal efficiency of capital

Planned investment can change at each rate of interest. For example a rise in the expected rates of return on investment projects would cause an outward shift in the marginal efficiency of capital curve. This is shown by a shift from MEC1 to MEC2 in the diagram below.

Conversely a fall in business confidence (perhaps because of fears of a recession) would cause a fall in expected rates of return on capital investment projects. The MEC curve shifts to the left (MEC3) and causes a fall in planned investment at each rate of interest.

The importance of hurdle rates for investment

British firms are continuing to demand rates of return on new investments that are far too high, undermining industry's ability to re-equip and close the productivity gap with competitor countries according to a survey by the Confederation of British Industry. “Hurdle rates" for major investment projects are 50 per cent higher than they need to be, while the payback periods required are much shorter than in countries such as Germany.

The CBI survey of more than 300 firms showed that they expected to earn an internal rate of return averaging 17 per cent and recover the cost of their investment in two to four years. But experts said that post-tax real returns of 10 per cent were sufficient to justify most investments.

Britain's poor investment record has been a concern both for the CBI and government ministers. Gordon Brown believes that low investment is one of the main reasons for sluggish economic performance, and that macroeconomic stability and a tax regime less biased towards dividends will encourage capital spending.

The CBI survey shows that small firms set the highest hurdle rates - averaging 24 per cent. Two thirds of all firms said that projects which failed to meet the required level of return were seldom or never given the go-ahead.