When Lower Interest Rates Slow Down Private Investment: Evidences from United States and Japan

Following the reflections in the General theory of the firm framework which showed that the relationship between investment and interest rate is not monotonous, this paper aimed (i) to carry out more precise theoretical investigations and empirical tests on the said relationship. Important theoretical advances have thus been made. First, the elasticity of investment with respect to lending interest rate is a function of several economic variables: (i) total of investment, (ii) interest rates in capital markets, (iii) expected retained earnings, (iv) respective stocks of capital financed by equity and on loans, (v) supplies of equity and loanable funds, as well as (vi) tax rate on business profits. Second, when firms are heavily rationed on funding, (i) the interest rate elasticity of investment is equal to 0 if the supply of loanable funds is insensitive to changes in the lending interest rate; (ii) it is positive if: (a) firms’ aversion to paying interest is high, (b) the guarantee system is relatively efficient and (c) the supply of loans is relatively elastic with respect to the interest rate ; (iii) it is negative if the effectiveness of the guarantee system is quite limited and the supply of credit is inelastic with respect to the interest rate. Third, when the lending interest rate is relatively low, the interest rate elasticity of investment is negative if the expected rate of return on equity is sufficiently lower than the cash flow ratio of firms relative to capital stock. On the other hand, when the lending interest rate is relatively low, this elasticity would be positive during the period of strong speculation on the stock market. Econometric tests have confirmed this last result: the long run and short run elasticities of investment with respect to the lending interest rate were positive in United States and in Japan during the period 1996-2012 characterized by strong speculation on stocks markets. Thus, standardizing the use of the interest rate as a tool to boost private investment regardless of economic and financial conditions is inadequate and risky.

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