Suppose that capital becomes more productive. What would we expect to happen? Choose one: A. The equilibrium interest rate and amount invested would both decrease. B. The equilibrium interest rate would decrease while the equilibrium amount invested would increase. C. The equilibrium interest rate would increase while the equilibrium amount invested would decrease. D. The equilibrium interest rate and amount invested would both increase.

D. The equilibrium interest rate and amount invested would both increase.

When capital becomes more productive, it means that the returns on investments in capital goods increase. Businesses can get more output for the same amount of input, making it more lucrative to invest in capital. As a consequence, the demand for investment funds to purchase or upgrade capital tends to rise. This increase in demand for investment funds pushes the equilibrium interest rate up because investors can now earn a higher return on their investments and would be willing to lend their money at a higher rate.

At the same time, despite the higher interest rates, the amount invested also increases because the higher productivity of capital means that firms are willing to pay the higher interest rates in exchange for the higher returns they expect from their more productive capital investments. In this situation, both the cost of borrowing (interest rate) and the amount invested rise until a new higher-interest equilibrium is reached where the supply of savings meets the demand for investments.