The Impact Of Interest Rate On Domestic Investment

LITERATURE REVIEW

2.1 Conceptual Literature

2.1.1 The Concept of Interest Rate

According to Sanusi (2002), interest rates are the costs a borrower has to pay when obtaining a loan in any economy. This definition implies that, interest rates are the determinants of the cost of credits in an economy. The impact of high cost of interest rates in the society is not unconnected to the fact that borrowers may hesitate to borrow when they should. This may be because the cost of credit and the credit itself may aggregate to an amount that may be unaffordable to the borrower to pay back within the stipulated due date of the loan. The implication of this on the economy is that GDP of the economy would be low since equity financing alone cannot adequately sponsor the production activities in an economy

According to Keynes, the interest rate is the reward for not hoarding, but for parting with liquidity for a specific period of time. Keynes’ definition of interest rate focuses more on the lending rate. Adebiyi (2002) defines interest rate as the return or yield on equity or the opportunity cost of deferring current consumption in the future. Some examples of interest rate include the saving rate, lending rate, and the discount rate.

Professor Lerner, in Jhingan (2003), defines interest as the price which equates the supply of credit or savings plus the net increase in the amount of money in the period, to the demand for credit or investment plus net hoarding in the period. This definition implies that an interest rate is the price of credit, which like other price is determined by the forces of demand and supply; in this case, the demand and supply of loanable funds (Jelilov, Gylych; Muhammad Yakubu, Maimuna, 2015).

Ibimodo (2005) defined interest rates, as the rental payment for the use of credit by borrowers and return for parting with liquidity by lenders. Like other prices, interest rates perform a rationing function by allocating limited supply of credit among the many competing demands.

Bernhardsen (2008) defines the interest rate as the real interest rate, at which inflation is stable and the production gap equals zero. That interest rate very often appears in monetary policy deliberations.

However, Irving Fisher (1936) states that interest rates are charged for a number of reasons, but one is to ensure that the creditor lowers his or her exposure to inflation. Inflation will cause a nominal amount of money in the present to have less purchasing power in the future. Expected inflation rates are an integral part of determining whether or not an interest rate is high enough for the creditor (Jelilov, 2016).

The real interest rate represents a fundamental valuation of temporary provision of capital (money) corresponding to a price level constant in time. It is also obvious from the above relation that if inflationary expectations change, nominal interest rates have to change aliquot at a constant real interest rate (Cottrell, 2005).

The real interest rate concept is irreplaceable in the research into the mutual relations of inflation, because assuming that the creditors are rational, inflation and nominal interest rates influence each other. For similar reasons, the real interest rate is used in broader economic analyses. Expected inflation is an unobservable quantity. In an expose analysis, it can be replaced by the actual rate of inflation in the following period, which is equivalent to assuming rational expectations (Bencik; 2009).

2.1.2 The Concept of Investment

This refers to real capital formation that will produce a stream of goods and services for present and future consumption (Bannock, Baxter & Rees, 2003). In common terms, investment is defined as the capital formation in the production. Stiglitz (1993) defines investment as the acquisition of an asset with the aim of receiving a return. It could also mean the production of capital goods; goods which are not consumed but instead used in future production. An example includes building of rail roads or factory. There are several motive for investment, the basic motive is profit/return. According to Keynes theory, this motive depends on the expected marginal efficiency of capital (MEC) in relation to the expected rate of interest. Investment is categories into public and private investment (induced and autonomous). Public investments are the investment which are being carried out by the government in order to provide social amenities to her citizens such as the provision of electricity, housing, good roads, and so on. While private investments are carried out by the individuals in the economy, they source for funds from the financial institutions to establish industries in the economy.

2.2 Theoretical Literature

2.2.1 The Classical Theory of Interest Rate

The rate of interest according to the classical is determined by the supply and demand for capital. The supply of capital is governed by the time preference while the demand for capital is determined by the expected productivity of capital. Time preference and productivity of capital depend upon waiting or saving. The demand for capital is determined by the investors because it is productive. Additional units of capital are not as productive as the earlier units. That is, the rate of interest is just equal to the marginal productivity of capital and it means that at a higher rate of interest, the demand for capital is low and it is high at a lower rate of interest. Thus, the demand for capital is inversely related to the rate of interest and the demand schedule for capital or investment curve slope downward from left to right. The supply of capital depends on saving, rather than the will to save and the power to save of the individual or community. Some individuals save irrespective of the rate of interest. Classical economists are of the view that, the higher the rate of interest, the larger will be the individual saving and the supply of funds.

2.2.2 The Loanable Funds Theory of Interest Rate

The neo-classical or the loanable fund theory examines interest rate in terms of demand and supply of loanble funds or credit. According to this theory, the rate of interest is the price of credit which is determined by the demand and supply for lonable funds. In the words of Prof Lerner in Jhingan (1992); it is the price which equates the supply of credit, or saving plus the net increase in the amount of money in a period, to the demand for credit, or investment plus net hoarding in the period. The demand for loanble fund has primarily three source; government, businessmen and consumers who need them for purpose of investment, hoarding and consumption. The government borrows funds for constructing public works or for war preparations. The businessmen borrow for the purpose of capital goods and for starting investment projects. Such borrowings are interest elastic and depend mostly on the expected rate of profit as compared with the interest rates. The demand of loanable fund on the part of consumers is for the purchase of durable consumer goods like scooters, houses etc. individuals borrowings are also interest elastic. The tendency to borrow is more at a lower rate of interest at a higher rate.