Question

Explain how interest rates affect the level of investment demand in an economy (Think about nominal/real rates, anticipated and unanticipated inflation).

Answer 1

Ans. An investment is made to earn a profit. So, for investment purpose either the investor borrows money or uses his personal funds. The cost of borrowing money is the interest charged on tge loan and cost of using his personal funds is the interest rate he could have earned if he kept these funds in a bank. Both these costs are nominal because they are adjusted for expected inflation. Now an investor will only undertake an investment if the rate of return on this investment is higher than or atleast equal to the cost of funds being used.

If the inflation doesn’t come out as expected, suppose is more than what was expected, this will lead to reduction in real cost of funds because real interest rate will fall as nominal interest rate is fixed beforehand. This will induce investment as borrowing cost has decreased.

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