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Interest Rates and Backward-Bending Investment

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  • Raj Chetty

Abstract

This paper studies the effect of interest rates on investment in an environment where firms make irreversible investments and learn over time. In this setting, changes in the interest rate affect both the cost of capital and the cost of delaying investment. These two forces combine to generate an aggregate investment demand curve that is always a backward-bending function of the interest rate. At low rates, increasing the interest rate stimulates investment by raising the cost of delay. Existing evidence supports the hypothesis that firms change the time at which they invest in response to changes in interest rates. The model also generates a rich set of additional predictions that can be tested empirically.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10354.

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Date of creation: Mar 2004
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Publication status: published as Chetty, Raj. “Interest Rates and Backward-Bending Investment.” Review of Economic Studies 74, 1 (2007): 67-91.
Handle: RePEc:nbr:nberwo:10354

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  1. Giuseppe Bertola & Ricardo J. Caballero, 1991. "Irreversibility and Aggregate Investment," NBER Working Papers 3865, National Bureau of Economic Research, Inc.
  2. Caballero, Ricardo J, 1994. "Small Sample Bias and Adjustment Costs," The Review of Economics and Statistics, MIT Press, vol. 76(1), pages 52-58, February.
  3. Demers, Michel, 1991. "Investment under Uncertainty, Irreversibility and the Arrival of Information over Time," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 333-50, April.
  4. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-85, December.
  5. Leahy, John V, 1993. "Investment in Competitive Equilibrium: The Optimality of Myopic Behavior," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 1105-33, November.
  6. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  7. Ricardo J. Caballero & Eduardo M. R. A. Engel & John C. Haltiwanger, 1995. "Plant-Level Adjustment and Aggregate Investment Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 1-54.
  8. Ricardo J. Caballero, 1997. "Aggregate Investment," NBER Working Papers 6264, National Bureau of Economic Research, Inc.
  9. Bischoff, Charles W, 1969. "Hypothesis Testing and the Demand for Capital Goods," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 354-68, August.
  10. Boyan Jovanovic & Peter L. Rousseau, 2004. "Interest Rates and Initial Public Offerings," NBER Working Papers 10298, National Bureau of Economic Research, Inc.
  11. Cukierman, Alex, 1980. "The Effects of Uncertainty on Investment under Risk Neutrality with Endogenous Information," Journal of Political Economy, University of Chicago Press, vol. 88(3), pages 462-75, June.
  12. Marglin, Stephen A, 1970. "Investment and Interest: A Reformulation and Extension of Keynesian Theory," Economic Journal, Royal Economic Society, vol. 80(323), pages 910-31, December.
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Cited by:
  1. Andrea Beccarini, 2007. "Investment sensitivity to interest rates in an uncertain context: is a positive relationship possible?," Economic Change and Restructuring, Springer, vol. 40(3), pages 223-234, September.
  2. Boyan Jovanovic & Peter L. Rousseau, 2004. "Interest Rates and Initial Public Offerings," NBER Working Papers 10298, National Bureau of Economic Research, Inc.
  3. Shaun K. Roache, 2006. "Domestic Investment and the Cost of Capital in the Caribbean," IMF Working Papers 06/152, International Monetary Fund.
  4. Shaun K. Roache, 2006. "Domestic Investment and the Cost of Capital in the Caribbean," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 6(3).

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