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Business Administration QUESTION #9609
Question 1
A central bank raises its policy interest rate by 200 basis points. Trace the complete transmission mechanism to a small manufacturing firm's investment decision.
  • Higher policy rate → higher interbank lending rates → higher commercial lending rates → higher cost of capital for the firm → reduced NPV of investment projects → deferral of capital expenditure✔️
  • Higher policy rate → lower bond prices → higher equity risk premium → firm issues more equity to avoid expensive debt → diluted ownership but unchanged investment level
  • Higher policy rate → currency appreciation → cheaper imports → lower input costs for the firm → improved margins offset higher borrowing costs → net investment effect is neutral
  • Higher policy rate → reduced government borrowing → fiscal surplus → tax cuts → higher consumer demand → firm increases investment to meet demand
Correct Answer Explanation
The monetary policy transmission mechanism: policy rate rise → interbank rate rise → commercial bank lending rates rise (cost of debt increases) → firm's WACC rises → projects that were previously NPV-positive at lower WACC become NPV-negative at higher WACC → marginal investment projects are deferred or cancelled → aggregate capital expenditure falls. This is the investment channel of monetary transmission, and it explains why interest rate policy is the primary tool for managing aggregate demand and investment cycles.