Question

What are some potential impacts that can occur in an economy from a changing real rate of interest?

Answer 1

The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.

1 +i = (1+r)(1+?_e)

where,

i= nominal interest rate

r= real interest rate

?_e=expected inflation rate

Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money.

impacts of change in real interest rate:

• If real interest rates are high, the cost of borrowing may exceed the real physical return of some potentially purchased machines (in the form of output produced); in that case those machines will not be purchased.
• Lower real interest rates would make it profitable to borrow to finance the purchasing of a greater number of machines.
• When the real rate of interest is high, that is, demand for credit is high, then money will, all other things being equal, move from consumption to savings.
• When the real rate of interest is low, demand for credit is low, demand will move from savings to investment and consumption.
• International capital moves to markets that offer higher real rates of interest from markets that offer low or negative real rates of interest triggering speculation in equities, estates and exchange rates.