Interest Rate in Its True Form: Explanation, Mathematical Representation, and Illustrative Example
The real interest rate, calculated by subtracting the expected inflation rate from the nominal interest rate, plays a pivotal role in shaping investment decisions and purchasing power in the economy.
### Impact on Investment Decisions
A lower real interest rate reduces borrowing costs for businesses and entrepreneurs, making investments more attractive as the expected returns outweigh the financing costs. This conventionally stimulates economic activity by incentivizing firms to invest more in production. However, research suggests that declining real interest rates could lead to suboptimal allocation of capital, with capital potentially flowing from more to less productive entrepreneurs, potentially decreasing the overall efficiency and output of the economy.
Conversely, a higher real interest rate increases borrowing costs, which can deter investment since fewer projects will yield returns above this higher cost of capital. This leads businesses to reduce spending on growth and expansion.
### Impact on Purchasing Power
The real interest rate reflects the true return on savings after accounting for inflation, essentially measuring how much purchasing power savers gain or lose over time. A positive real interest rate means savings grow in value, increasing purchasing power. For consumers and savers, higher real interest rates mean they can earn more on their savings, boosting future purchasing power.
On the other hand, lower real interest rates erode the value of saved money relative to inflation, reducing purchasing power. From a borrowing perspective, if real interest rates are low or negative (nominal rates below inflation), debtors benefit since they repay loans with money worth less in purchasing power, encouraging borrowing and spending.
### Summary
| Aspect | Effect of Higher Real Interest Rate | Effect of Lower Real Interest Rate | |----------------------------|----------------------------------------------------|-----------------------------------------------------| | **Investment decisions** | Discourages borrowing and investment; restricts economic growth[2][3] | Encourages borrowing and investment; may increase economic activity but with risk of inefficient capital allocation[2][3] | | **Purchasing power (savers)** | Increases purchasing power; savings grow in real terms[1] | Decreases purchasing power; savings erode relative to inflation[1] | | **Purchasing power (borrowers)** | Decreases borrowing incentives; debt is costlier in real terms[1][3] | Increases borrowing incentives; debt repaid with less valuable money[1][3] |
In essence, the real interest rate is critical for balancing economic growth and inflation control by influencing how much businesses invest and how consumers save or spend, ultimately affecting overall purchasing power and economic vitality. The Fisher effect further explains that changes in inflation expectations adjust nominal rates so that real interest rates remain stable in the long run, thus affecting investment and consumption decisions accordingly.
It is essential for investors to consider current and expected inflation rates when deciding where to put their money, as the inflation rate erodes the value of an investment's return, decreasing the rate of return. If the inflation rate is higher than the nominal rate of return on investments, investors could earn a negative rate of return.
- In the context of personal finance, higher real interest rates can enhance the purchasing power of savers by allowing their savings to grow in real terms, thus boosting their future spending capacity.
- Conversely, lower real interest rates can diminish the purchasing power of savers' money relative to inflation, reducing the long-term value of their savings and future purchasing capacity.
- In the world of digital finance, lower real interest rates may incentivize investments in decentralized finance (defi) projects, as the expected returns can potentially outweigh the financing costs, especially for Initial Coin Offerings (ICO) that issue new token offerings. However, investors should be cautious, as such investments may not always be productive or efficient, potentially leading to suboptimal allocation of capital.
