Investment is a component of private spending that comes after consumption.
The decision to invest or not to invest is made after comparing the marginal cost of an investment option with its marginal benefit.
The interest rate paid for borrowing funds is the marginal cost while the expected rate of return on an intended business is the marginal benefit.
The decision to invest is made when the expected rate of return exceeds the interest rate. The excess is the expected profit.
Therefore, expected rate of returns and the interest rate are two key determinants of investment spending.
What is real interest rate?
Interest rate is the financial cost of borrowing the money capital required to purchase the real capital.
The impact of interest rate on investment is not limited to funds borrowed for financing. When a business uses money from savings to invest, it incurs an opportunity cost by foregoing interest income that would have been earned by lending the money.
Now, It is the real interest rate and not the nominal rate (or money interest rate), that is important to an investment decision.
What is the difference between nominal interest rate and real interest rate?
The nominal interest is expressed in a currency or current value while the real interest rate is expressed in currency of constant or an inflation-adjusted value. the real interest rate is the nominal rate less the rate of inflation.
An example should add clarity. An investment that is expected to yield a real (inflation adjusted) rate of return of 15 percent and the nominal interest rate is 20 percent would be considered unprofitable.
But assuming that there is a recurring yearly inflation rate of 15 percent, an investing business will pay back an amount approximately 15 percent less in purchasing power.
Recall, the nominal interest rate is 20 percent, the real interest rate is:
Nominal interest (20%) – yearly inflation rate (15%) = 5 percent.
The real interest rate of 5 percent is less than the expected real rate of return of 15 percent.
The investment will be profitable because the real rate of return exceeds the real interest rate by 10 percent (15% – 5%)..
The nominal interest rate is equal to the real interest rate plus the inflation rate. The nominal interest rates are the ones advertised by financial institutions.
You can use them side by side the inflation rate to determine the real interest rate.
Then compare the real interest rate to the expected rate of return on an investment option to reach an investment decision.