Interest Rates and Backward-Bending Investment

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.