The Impact Of Interest Rate On Domestic Investment

2.2.3 Keynes Liquidity of Preference Theory of Interest Rate

Keynes defines the rate of interest as the reward of not hoarding but the reward for parting with liquidity further specified period. It is not the price which brings into equilibrium the demand for resources to invest with the readiness to abstain from consumption. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash. In other words, the rate of interest in the Keynesian sense is determined by the demand for and the supply of money.

2.2.4 Accelerator Theory of Investment

The simple accelerator model asserts that investment spending is proportional to the change in output and is not affected by the cost of capital. This theory was advanced by Clark (1917). The simple (also called naïve) accelerator model was based on the view that firms install new capital when they need to produce more. Therefore, firms would invest if output was expected to change, but they would not otherwise undertake net investment. The simple accelerator model did a reasonable job of explaining the data but was regarded as inadequate since it failed to take the costs of investing into account. Much research has been devoted to the question of whether the cost of capital significantly affects investment. If the accelerator model is extended by relating investment to current and past changes in income, it seems in some studies to do a better job in explaining investment than the neoclassical model. This finding would imply that the cost of capital is not a major determinant of the rate of investment.

2.2.5 Tobin Q Theory of Investment

James Tobin (1969) propounded the theory of Tobin Q. Tobin Q is the ratio of market value of a firm to replacement cost of capital. When the ratio is more than one, firms will want to invest more capital, such that investment will be rapid. When the ratio is equal to one or unity, then firms would be indifferent as to whether to invest more capital or not. When the ratio is less than one, then the firm would be better off selling the existing assets than acquiring new ones. One critique of Tobin Q is that it is difficult to measure or quantify replacement costs. For empirical consideration, the average Q, which is the ratio of the market value of the existing stock of capital to its replacement costs, is often used instead of the marginal Q which is hard to measure. Tobin Q’s application to developing countries is limited in the sense that it makes oversimplifying assumptions such as perfect capital markets, perfect flow of information and little or no public investment. Developing countries lack well-developed capital markets and suffer from financial repression, huge national debts, influx of imports and macroeconomic instability (Ag’enor and Montiel, 1996). Kenya, for a long time has suffered the effects of corruption and bad governance, and it would be important to see how these two factors affect domestic private investments.

2.2.6 Keynes Theory of Investment 

Keynes (1936) advanced his theory of investment based on ‘animal spirits’. He stated that despite the fact that investment and savings must be identical expost, savings and investment decisions are generally taken by different decision-makers hence there was no reason why ex post savings should equal ex ante investments. Keynes formulated an investment function of the form I = I0 + i(r), where I is investment, I0 is autonomous investment and i(r) is interest rates. Investment is inversely proportional to interest rates. The higher the interest rate, the less likely the firm will be willing to undertake any given investment project. In this regard, Keynes stated that firms rank various investment projects depending on the internal rate of return (IRR), or marginal efficiency of investment. Given a certain rate of interest, firms would choose projects whose IRR exceeded the rate of interest. The criticism of this theory was that ranking of investments may most likely be dependent on interest rates.

2.3 Empirical Literature

In this section of the research, some of the related studies previously carried out on the subject matter were reviewed in this section of the study.

Utile et al (2018) investigated the effect of interest rate on the economic growth of the Nigerian economy. The aim of the study was to determine the effect of inflation rate, exchange rate and deposit interest rates on the gross domestic product of the country. The data for the study was obtained from the statistical bulletin of the Central Bank of Nigeria from 1980-2016. The research design adopted for the study was the ex-post facto research design. Multiple regression technique was used for the analysis of data. The student t-test was used to test the hypotheses formulated. It was found that INF and EXR have negative and insignificant effect on GDP. Also it was found that DIR has positive and significant relationship with GDP. The study generally concludes that interest rate has a negative and insignificant relationship with GDP.

Chris (2012) investigated the effect of interest rate fluctuation on the economic growth of Nigeria. Two research hypotheses were formulated to investigate the relationship between interest rate and economic growth and the difference in economic growth before and after interest rate deregulation regime in Nigeria. Ex-post facto research design was adopted for this study. Data for the study were obtained from the Central Bank of Nigeria statistical bulletin. Data collected were analyzed and tested using the ordinary least square multiple regression analytical technique. The result of the findings revealed that: there existed an inverse relationship between interest rate and economic growth in Nigeria, meaning that increase in interest rate will decrease GDP of the country, thus retarding growth of the real sector. It was recommended that a strong monetary policy for Nigeria should be evolved that would enhance lending to the real sector economy for productive economic activities.

Fatoumata (2017) with the application of regression technique examined the impact of interest rate of economic growth in Nigeria from 1990 to 2013. The result found that the interest rate has a slight impact on growth; however the growth can be improved by lower the interest rate which will increase the investment. As a result of the study was found out that Nigerian authorities should set interest rate policies that will boost the economic growth. Therefore, proper measure should be taken in order to have a more rapid economic growth.