A fall in interest rates will not lead to an increase in foreign direct investment.

Introduction

Interest rate is the cost of borrowing and the reward for lending. Foreign direct investment refers to direct investment made in the economy by foreign firms.

Many students think that a fall in interest rates will lead to an increase in foreign direct investment. Mr. Edmund Quek will engage in a more detailed discussion with the students in economics tuition on this economic misconception.

Exposition

A fall in interest rates will lead to a fall in the costs of borrowing. When this happens, the number of profitable planned investments will increase which will induce firms to increase investment expenditure. Investment expenditure comprises investment expenditure made by domestic firms and investment expenditure made by foreign firms which is called foreign direct investment. It is correct to say that a fall in interest rates will lead to an increase in investment expenditure made by domestic firms as they generally borrow in the domestic economy to finance their investments. However, many students think that a fall in interest rates will also lead to an increase in foreign direct investment. This is erroneous. Unlike domestic firms, foreign firms generally do not borrow in the domestic economy to finance their investments as they have foreign sources of funds. Foreign direct investments are typically made by multinational corporations which generally raise funds to finance their investments through issuing shares and bonds. Although interest will be paid on these corporate bonds, the interest rates on these corporate bonds, which are called coupons, are independent of the interest rates in any economy. Therefore, a fall in interest rates in the domestic economy will not affect the costs of borrowing of multinational corporations and hence will not influence their decisions to invest in the domestic economy, at least not significantly. A good understanding of the fact that foreign direct investment is not affected by changes in interest rates is of great importance in the examination. This is particularly true when the question requires students to discuss the effects of an economic event on the balance of payments.

 

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Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek