When looking at interest rates a person will need to distinguish between the nominal interest rate and the real interest rate. The nominal interest rate is the interest as usually reported, it’s the rate investors will pay to borrow money. The real interest rate is the nominal rate corrected for the effects of inflation.
The graph above slopes downwards to indicate as interest rate rises the quantity of investment demanded falls.
The fiscal policy affects investments, when the government changes it’s spending or the level of taxes in the economy output for goods and services, national savings and investment affects people spending and borrowing power. If the government was to increase spending the immediate impact would mean an increase in demand for goods and services, as output is fixed by the capacity of a factory production the increase in one area is met by a decrease in other areas, such as investment. This is caused by as the government increasing purchases forcing interest rates to increase and investments to decrease; this is the government’s way of crowding out investment.
The demand for investments might increase through technological innovation, i.e. rail road, but before a firm or household can take advantage of this innovation it must invest in goods, as the railroad has no value until investment into laying tracks and building carriages has taken place. Investment demand changes through the government tax laws. If the government was to increase personal income taxes and uses the extra income to cut tax for those who invest in new capital, such a change would make investment projects profitable increasing the demand for investment goods.
A further look into nominal and real interest rate and how it is worked out, suppose you deposit your savings in a bank account that pays 8 percent interest yearly. Next year, you withdraw your savings along with the accumulated interest earned which makes you have 8% more money than when you first made the deposit a year earlier. Certainly you have 8% more money than you had before, but if prices have risen by a rate of 5%, and then the amount of goods you can buy has increased by only
3 percent, and if the inflation rate was 10%, then your purchasing power has fallen by 2%. Economists call the interest rate the bank pays the nominal interest rate and the increase in your purchasing power the real interest rate.
There is no easy way of working out real interest rates because when a borrower and lender agree on a rate it’s normally the nominal rate, as both parties do not know the what the rate of inflation might be over the term of the loan. They do have some expectation of the inflation rate. Although recent data has shown over the late twentieth century that high interest rates did not accompany high inflation, these rates are not often observable but we can examine the persistence of inflation. Inflation can be very persistence when it’s high in one year it’s usually high in the next.
If real interest rate is not adjusted to equilibrate savings and investments we make an assumption that this is a small open economy with perfect capital mobility, by using the tem perfect mobility I’m pointing out that the residents of the country have full access to the world of financial markets, meaning the government dose not impede international borrowing or lending. It would allow residents of the small open economy the need to never borrow at above the rate set by its country, as they could get a loan from abroad of a lower interest rate.
The above graph shows the saving and investment in a small open economy. In a closed economy, the real interest rate adjusts to equilibrate saving and investment. In a small open economy, the interest rate is determined in world financial markets. The difference between saving and investment determines the trade balance. Here there is a trade surplus, because at the world interest rate, saving exceeds investment.
The Market for loan able Funds in an open economy’s saving S is used in two
Ways: to finance domestic investment I and to finance the net capital outflow.
S = I + CF.
Consumption depends positively on disposable income the amount of income after all taxes have been paid. The higher the disposable income is the greater consumption will be. The quantity of investment goods demanded depends negatively on the real interest rate. For an investment to be profitable, its return must be greater than its cost.
Because the real interest rate measures the cost of funds, a higher real interest rate makes it more costly to invest, so the demand for investment goods falls.
When the government increases taxes, disposable income falls, and therefore consumption falls as well. For an investment to rise, the real interest rate must fall. Therefore, a tax increase leads to a decrease in consumption, an increase in investment, and a fall in the real interest rate. If a technological advance improves the production function, this is likely to increase the marginal products of both capital and labour.
Bibliography
N.G. Mankiw – Macroeconomics 5th Edition - Chapter 4 Money and Inflation (Whole Document)
O. Blanchard – Macroeconomics (Hard Cover) 4th Edition – Chapter 19. The Goods Market in an Open Economy (Pages 4-5 within my text)
D. Romer - Advanced Macroeconomics (Hard Cover) - Chapter 6: Microeconomic Foundations of Incomplete Nominal Adjustment (Whole Document)
S. Williamson – Macroeconomics - Chapter 7. Income Disparity among Countries and Endogenous Growth (Page 5 within my text)
