In 2023, the inflation rate in India was 4.2% and the nominal interest rate on business loans is 7.9%. Using the Fisher approximation, calculate the real interest rate and explain how this rate would influence a small business's decision to invest in new machinery.
Answer
Real interest rate is 3.7%; it reduces borrowing cost in real terms, encouraging investment in new machinery.
The correct answer is Real interest rate is 3.7%; it reduces borrowing cost in real terms, encouraging investment in new machinery. — Lower real rate means cheaper real borrowing, which encourages investment.
Step-by-step solution
- Recall Fisher approximation: real rate ≈ nominal rate – inflation rate.
- Subtract inflation 4.2% from nominal 7.9%.
- Real interest rate = 3.7%.
- Lower real rate means cheaper real borrowing, which encourages investment.
Common mistake: Adding inflation instead of subtracting from nominal rate
Concept tested: Real interest rate calculation
Published · How this solution was prepared and checked
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