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What is the difference between nominal and real interest rates? Explain the relationship between the interest...

What is the difference between nominal and real interest rates? Explain the relationship between the interest rate and investment by graph. If the interest rate increases how does change investment, aggregate demand (AD) and output? Why?

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Answer #1

Nominal rate of interest is unadjusted for inflation while real rate of interest is adjusted for inflation. The formula of calculating nominal rate of interest:

Nominal interest rate = Real Interest rate + Inflation rate

Banks and other financial institutions generally impose nominal rate of interest on their loans. Interest rate and Investment have inverse relationship with each other. If there is rise in rate of interest, investment level will fall because it will raise cost of borrowing for investors.

Aggregate demand = Consumption + Investment + Government spending + Exports - Imports

Fall in Investment level due to rise in rate of interest will reduce agggregate demand in an economy. It will shift demand curve from AD to AD1 which will reduce price level from P to P1 and output level from Y to Y1.

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