Explain why and how investment depends on the real interest rate.

Explain why and how investment depends on the real interest rate.

Expert Solution

Real interest rate is the rate of interest adjusted for inflation. It takes into account the price level changes. It can be calculated as:

Real Interest Rate = Nominal Interest Rate - Rate of Inflation

Investment is inversely related to the real interest rate. If the interest rate is too high then it increases the cost of borrowing and the rate of return of investment needs to be very high in order to make it profitable. On the other hand, if the rate of interest is low then it encourages investment.

If inflation rate is 8% and the nominal interest rate is 7% then the real interest rate is negative (-2%). The investors will desire to borrow more as inflation in the economy will make it easier to pay it back. On the other hand if the inflation rate is 4% and the nominal interest rate is 9% then the real interest rate is 5%. So, there exists an inverse relationship between the investment and interest rate.

Rahul Sunny answered 2 years ago

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