Key Takeaways
- Central bank interest rate changes transmit to corporate investment through various channels, but the direct impact of borrowing costs is crucial and complex.
- New research uses hypothetical scenarios to directly measure how firms adjust investment plans to changes in loan rates, isolating the borrowing cost channel
- A 1 percentage point decrease in loan rates can raise planned investment by about 6-7%, but this effect is heterogeneous across firms and sensitive to the size of the rate change.
- Many firms do not adjust investment in response to lower borrowing costs due to sufficient internal funds or because they are not operating at the investment margin.
- The direct borrowing cost channel plays a significant role in monetary policy transmission, although many firms do not explicitly consider general equilibrium effects.
Understanding the Link Between Interest Rates and Corporate Investment
Central banks have recently made significant adjustments to interest rates, yet the precise way these policy rates influence corporate investment remains a complex area. The core question is whether lower borrowing costs directly lead firms to increase their investment spending. While aggregate evidence suggests substantial effects on investment, often linked to lower credit costs, these broader impacts encompass indirect factors like demand, making it difficult to isolate the pure effect of financing expenses.
For policymakers, accurately quantifying this direct channel and understanding how its effectiveness changes over time and across different economic conditions is vital. Recent economic models also increasingly highlight the importance of this direct borrowing cost channel for both diverse households and businesses.
A New Survey Approach to Gauge Interest Rate Impact
A recent study (Best et al. 2025) offers novel insights into how interest rates affect corporate investment at both micro and macro levels. By presenting firms with hypothetical loan rate changes, the research effectively isolates the direct influence of borrowing costs on investment decisions. The study utilizes open-ended survey responses to uncover why some companies opt not to adjust their investments and the extent to which financing comes into play in managers’ thinking about monetary policy.
Complementary survey questions and linked financial data further enhance the analysis. Integrating these findings into a large panel of German firms allows for a comparison between survey responses and actual firm behavior during periods of monetary policy shifts. The research draws on the ifo Business Survey, a monthly survey of a representative sample of German companies, typically completed by senior executives. The main dataset comprises over 3,200 firms.
Firms’ Investment Adjustments in Response to Loan Rate Changes
In December 2023, participating firms were asked to consider hypothetical scenarios involving a reduction in loan rates by 0.5, 1, 3, or 4 percentage points, expected to last for two years, with all other factors held constant. This experimental setup is designed to isolate the causal impact of loan rates—a key component of the marginal cost of external finance for most German companies—on their investment activities. The hypothetical rate change was applied across all loan maturities and was set relative to firms’ current expected rates. At that time, the European Central Bank’s main refinancing rate stood at 4.5%, with expectations that it would remain elevated for the subsequent two years.
The results indicate that a one percentage point decrease in loan rates leads to an approximate 6% increase in planned investment in the following year, and about a 7% increase in the year after. A similar pattern is observed for a half-percentage point cut. For larger rate reductions of 3-4 percentage points, the investment increase rises significantly to 12-15%, suggesting a diminishing elasticity for more substantial rate changes. For comparison, the overall impact of monetary policy on corporate investment, which includes various transmission channels, is estimated at around 15% in the first year following a shock that reduces borrowing costs by 1 percentage point. This implies that the total effect of monetary policy is roughly double the impact stemming from borrowing costs alone.
Beneath these average figures lies substantial variation in investment adjustments. While a majority of firms report no change in their investment plans, those that do adjust typically revise them by a significant 18-30%. Among firms already planning to invest, the proportion that adjusts ranges from 30% for a 0.5 percentage point rate cut to 49% for a 4 percentage point cut. This adjustment rate is considerably lower for firms without pre-existing investment plans, which aligns with the concept of fixed adjustment costs, as illustrated in Panel B of Figure 1.
Firms with existing investment plans that did not adjust their investment were asked to elaborate on their reasoning. Two primary explanations emerged. Firstly, approximately 37% of firms stated they possess adequate internal funding, preferring to utilize these resources for investment, aligning with the pecking order theory of capital structure. Secondly, about 39% of firms indicated that they are not operating at the investment margin. This could suggest either a low marginal return on capital, implying a scarcity of additional profitable investment opportunities, or a high marginal return on capital, where investment decisions are dictated by capacity or technological requirements rather than financing costs.
Further analysis reveals that firms’ financial health significantly influences their sensitivity to interest rates. Companies that rely more heavily on external financing, have recently secured bank loans, or report experiencing financial constraints demonstrate a greater propensity to increase investment following a reduction in loan rates. Additionally, firms facing shortages of skilled labor and those in industries with longer capital goods lifecycles tend to adjust their investment more pronouncedly.
In a follow-up survey exercise, firms were asked how they adjust their required rates of return for new investments, often referred to as ‘hurdle rates,’ in response to changes in loan rates. Consistent with previous research, hurdle rates appear to be rather inflexible. A majority of firms did not alter their hurdle rates following a hypothetical loan rate cut. Although adjustments in hurdle rates are strongly correlated with adjustments in investment, firms are more inclined to change their investment plans than their hurdle rates. This suggests that the inertia of hurdle rates in the face of temporary loan rate fluctuations may not necessarily hinder investment decisions.
Assessing the Macroeconomic Significance of the Direct Borrowing Cost Channel
The research evaluates the role of the direct borrowing cost channel in monetary policy transmission through two distinct methods. Firstly, in a subsequent survey wave, firms were asked an open-ended question about the discussions and considerations that typically arise in their investment planning when the European Central Bank (ECB) adjusts its key interest rate. Notably, over half of the surveyed firms do not engage in discussions about the implications of monetary policy changes for their investment strategies.
A quarter of firms do refer to specific transmission channels, with one channel dominating: 83% cite the direct interest rate impact via external financing. This strongly suggests that the mechanism examined in the vignette study plays a crucial role in aggregate economic dynamics. Another 12% mention changes in demand resulting from interest rate adjustments, and 11% refer to general-equilibrium effects. These latter channels are more commonly cited by firms with high sensitivity to business cycle fluctuations, a finding consistent with models of rational inattention.
Secondly, the study leverages the panel nature of the survey data to ascertain whether firms’ hypothetical responses regarding borrowing cost sensitivity can predict their actual dynamics following monetary policy shocks. The researchers analyzed the monthly output movements of manufacturing firms within the sample in response to high-frequency identified monetary policy shocks over the past 23 years. Figure 3 demonstrates that firms expecting to adjust their investment in the hypothetical scenario exhibit lower output responses after monetary policy shocks. This relationship holds robustly even when accounting for numerous potential confounding factors, underscoring the critical importance of firms’ investment sensitivity to interest rates within the broader monetary transmission mechanism.
Key Policy Implications
The findings present at least three significant policy implications. Firstly, a considerable number of firms do not adjust their investment in response to decreasing borrowing costs, often because they have sufficient internal funds. During periods of heightened uncertainty, such as geopolitical risks, firms tend to build precautionary cash reserves, which further diminishes their responsiveness to changes in loan rates.
Secondly, firms’ sensitivity to borrowing costs appears to decrease as the magnitude of the change increases. This could be due to managerial bandwidth limitations or other factors. Consequently, monetary policy may become less effective when attempting to counteract weak demand, as larger rate adjustments might be needed to achieve a comparable impact.
Lastly, it is observed that many firms do not actively consider the general-equilibrium effects of monetary policy, a phenomenon consistent with ‘GE neglect.’ As a result, firms’ demand might be stimulated by monetary policy actions without managers directly attributing this boost to policy changes. This disconnect can lead to a slower transmission of monetary policy effects through the economy.