In 2023, the inflation rate in India is 4% and the nominal interest rate offered by banks on business loans is 8%. Calculate the real interest rate using the Fisher approximation and explain how this rate would affect the decision of a small business to invest in new machinery.
Answer
4%
The correct answer is 4% — Step 3: Recognise that a 4% real interest rate implies a relatively low cost of borrowing after inflation, encouraging the business to invest in machinery.
Step-by-step solution
- Step 1: Apply the Fisher approximation: .
- Step 2: Compute .
- Step 3: Recognise that a 4% real interest rate implies a relatively low cost of borrowing after inflation, encouraging the business to invest in machinery.
Common mistake: Subtracting inflation from nominal without considering the Fisher approximation
Concept tested: Real interest rate and investment decisions
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