Question

Distinguish between nominal and real interest rates. Which is more relevant in making investment and R&D decisions?

Answer 1

To understand nominal and real interest rates we must consider the Fisher equation. This says that r=i-P where r is the real interest rate, i is the nominal interest rate and P is the expected inflation rate. Thus the real interest rate is the nominal interest rate adjusted for the expected inflation in the economy. When considering investment and R&D decisions the real interest rate is more pertinent as it takes into account inflation and the cost of investment over time. Research and development is influenced by the cost of borrowing and also the discounted cash flow that the R&D prospectively gives. Thus in this case the real interest rate is more relevant.