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Real interest

The real interest rate is the nominal interest rate minus the rate of inflation, and thus is the interest rate adjusted for inflation. Real Interest Rate is the amount by which the nominal interest rate is higher than the inflation rate. The real rate of interest is approximated by taking the nominal interest rate and subtracting inflation. The real interest rate is the growth rate of purchasing power derived from an investment. There is a preference for “real” applications for savings such as consumption or real investment. Real interest rate compensates for delayed consumption or giving up real investment opportunities. The higher the desire for consumption or real investment opportunities the higher the real rate of interest.

The real rate of interest is determined by the demand and supply for savings at a given point in time. The real rate is the price needed to delay consumption of funds demanded for real investment. Upward shifts to the right (increases) in demand for desired real investment cause the real rate of interest to increase. If the supply of desired savings shifts upward (increases) to the right, the real rate of interest declines. The concept of real rate of interest is a most important theoretical construct in monetary policy. Monetary authorities use it as an instrumental measure to target the mandated or desired inflation rate. (Brahmananda, 2001)

Nominal interest

Nominal interest is the rate of interest specified in loan contracts, without adjustment for inflation. The annual return form lending money expressed as a percentage, without having taken account of the rate of inflation. Nominal means “in name only”, this is sometimes called the quoted rate. (McCracken, 2004) Normal Interest Rate is the stated rate of interest applied to certain investment process.

Nominal Rate of Interest only has an impact on firms’ investment decisions if they are accompanied by a change in the real interest rate. Research findings said that, empirical investigations of the relationship between investment and demand uncertainty seldom use appropriate empirical proxies that are close to the concept of demand uncertainty for which the theory is developed. Results show that demand uncertainty reduces both planned investment and realized investment (1991) for imperfectly competitive firms. There was no evidence of an effect of price uncertainty on investment, which is consistent with the assumption of price setting firms. Outcome show that demand uncertainty reduces the level of investment plans, and do so by a non-negligible amount. Butzen et al (2003), Guiso and Parigi (1999) and Patillo (1998) also report a negative effect of demand uncertainty on firms’ investment.

Finally, such results suggest that, on average, firms adjust their investment plans very little, although revisions may be substantial for some firms and years. Firms do not modify their investment decisions due to the fact that part of the uncertainty had disappeared between the time the investment was planned and the time investment is realized. This contrasts with the effect of uncertainty on the timing of investment, as stressed by the real-option theory. However, firms may revise their investment plans according to new information on their fundamentals. In particular firms may adjust their investment plans when observing sales growth, but they do so only slightly.

In summary, results indicate that the level of uncertainty affects investment plans, but that plans are not revised as a result of a change in uncertainty. This suggests that a reduction in the level of uncertainty would indeed enhance investment, but will do so with a lagged effect, since uncertainty affects investment plans but not revisions of current investment.

References:

McCracken, M. E. (2004). Kinds of interest rates

Brahmananda, PR (2001) Course of Real Interest Rates in US Economy

Ross, SA (2002) Fundamentals of Corporate Finance: Interest Rates and Bond Valuation, Massachusetts Institute of Technology

Patillo, C. (1998), “Investment, uncertainty and irreversibility in Ghana”, IMF Staff Papers, 45(3), 522-553.

Guiso, L. and G. Parigi (1999), “Investment and demand uncertainty”, Quarterly Journal of Economics, 114, 185-227

Caballero, R. (1991), “On the sign of the investment-uncertainty relationship”, American Economic Review, 81, 279-288

Butzen, P., C. Fuss and Ph. Vermeulen (2003), ” The impact of uncertainty on investment plans”, in Butzen, P. and C. Fuss (eds.), Firms’ Investment and Finance Decisions: Theory and Empirical Methodology, Cheltenham, UK: Edward Elgar, August 2003.