In 2022, the average inflation rate in India was 6.5% and the nominal interest rate offered by banks on business loans was 10.5%. Calculate the real interest rate and explain how this real rate influences business investment decisions.
Answer
Real interest rate = 4.0%; a lower real rate encourages firms to invest as the cost of borrowing is relatively cheap after adjusting for inflation.
Step-by-step solution
- Recall the formula: Real Interest Rate = Nominal Interest Rate – Inflation Rate.
- Substitute the given values: Real Rate = 10.5% – 6.5%.
- Perform the subtraction: 10.5% – 6.5% = 4.0%.
- Interpret the result: a 4% real cost of borrowing means the purchasing power of money borrowed is reduced by only 4% annually.
- Explain investment impact: when real rates are low, the expected return on projects needs to exceed only a small cost, making more projects viable and stimulating investment.
Common mistake: Using the formula Real = Nominal / (1 + Inflation) instead of subtraction for simple approximation.
Concept tested: Calculate real interest rate and its effect
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