interest-ratesTransitive logic suggests that higher returns attract greater investment, which in turn implies a higher domestic interest rate and leads to further investment (including from foreigners).
At the same time, however, a high domestic rate of interest would also imply sluggish business investment and consumer sectors (owing to the higher cost of borrowing) and quite likely a higher inflation rate and also a higher possibility of default. Therefore the country is likely to be fundamentally unattractive to foreign investors. (This contradicts the earlier conclusion that the country is attractive to foreigners.)
What are some empirical and theoretical perspectives on the impact of higher domestic interest rates on foreign investments?
I believe your presumption that high interest rates imply sluggish business investment and consumer spending is backwards. In fact, it is the positive growth prospects of private enterprise that leads to higher interest rates. Hence there is really no mystery, as higher growth prospects lead to higher rates and increased investment, eventually driving down rates as capital is allocated to successively less attractive enterprises. In theory, this process continues until all investments, foreign and domestic, are equally attractive. In practice, barriers to foreign investment and other frictions (e.g., taxes) may prevent this process from completely equalizing the attractiveness of global investments.
A lot depends on the various elasticities. For instance, higher national interest rates could attract more foreign investments, which in turn creates more opportunities for domestic entrepreneurs (an income effect). On the other hand, foreign investment could drive domestic investors out of the market (“a crowding out,” or substitution effect).
Likewise, if higher interest rates reflect a large supply (elasticity) of growth opportunities, that’s good. But if they are matched against a FIXED supply of opportunities and reduced profitability for them, that’s bad.
All content is licensed under CC BY-SA 3.0.