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Real Rate of Interest

The real rate of the interest is approximately equal to the nominal (money) rate of interest minus the expected rate of inflation. Investment decisions are also influenced by the real rate of interest, i.e., the cost of borrowing money for investment.

In brief, there is an inverse relationship between the real interest rate and the desired investment. At a high real rate interest, investment spending will be less, and vice versa. The relationship between real rate of interest and investment can be explained terms of different forms of investment.

(1)    Investment in Residential Buildings. Purchase of a new house involves heavy investment Spending. A household may not afford to Pay lumpsum amount for a new house. He has to take a home loan from a bank on any other financial institution. The household has not only to repay the principal amount of loan but interest interment spread over a long time. In case, the real rate of interest is high the demand for loans for housing will be less, and therefore, investment spending on the contraction of purchase of houses will be less.

Proposition 1. Spending for residential construction tends to vary negatively with interest rate.

(2)    Investment in Fixed Capital. Construction of factory buildings, shopping complexes, purchase of machinery, etc., are the examples of investment in fixed capital. This type of investment also involves large expenditure. Firms have to borrow from banks and other financial institutions for investment in fixed capital. In case, the rate of interest is high the demand for investment expenditure on fixed capital will be less, and vice versa.

Proposition 2. The higher the real interest rate the lesser will be the investment expenditure on fixed capital.

(3)    Investment on Inventory Building. Inventory building comprise stock of raw materials, semi-finished goods, work in progress and also unsold final products. Large sum of money spending is involved in inventory accumulation. Funds available with  a firm can either be used in inventory building or these can be invested elsewhere to earn income.

While taking investment decision the firm will compare the opportunity cost of inventory building and investing money elsewhere to earn income. The higher the rate of interest, the higher will be the opportunity cost of holding inventories of a given size, the smaller will be the spending on inventory building.

Proposition 3. The higher the real rate of interest, the lower is the desired inventory of goods and materials, and vice versa.

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