Given the expected relationship between the real interest rate and investment, h

Question

Given the expected relationship between the real interest rate and investment, how would you explain a scenario where investment continued to fall despite low or even negative real interest rates?

A. The relationship between the real interest rate and investment is usually expected to be negative. Changes in the level of investment, however, depend both on the level of real interest rates and changes in expectations about future business conditions. If firms are pessimistic about the economic outlook, investment may remain weak despite low or negative real interest rates.

B. The relationship between the real interest rate and investment is usually expected to be negative. Therefore, falls in the real interest rate should always be associated with a rise in investment. Economic forces must not be working correctly.

C. The relationship between the real interest rate and investment is usually expected to be positive. Therefore, it makes sense that falls in the real interest rate are associated with a fall in investment.

D. Investment should be unaffected by the real interest rate. Therefore, we should not consider the real interest rate when assessing the outlook for investment.

Explanation / Answer

It will be A.
The relationship between the real interest rate and investment is usually expected to be negative. Changes in the level of investment, however, depend both on the level of real interest rates and changes in expectations about future business conditions. If firms are pessimistic about the economic outlook, investment may remain weak despite low or negative real interest rates.

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