Economics is all about price determination.

At least since the Great Knut (Wicksell) we started to see the Interest Rate as the Price.

It was the most important price in the economy, its determination would set the course of economic development, both in the short as in the long run.

We still live in a Wicksellian world. Ask any Central Banker. Better yet, ask Michael Woodford, one of the leading macroeconomists.

But this post is not really just about interest rates.

It’s really about Real interest rates.

Since the Great Irving (Fisher) we learned to differentiate between the real and the nominal interest rate, so to avoid the Money Illusion.

The real interest rate is (roughly, only for small numbers) the nominal interest rate minus the ex post inflation rate. (Remember that, when we compare current interest rates with inflation this is not correct. Current interest reflects the gain we shall have in the future, current inflation reflects the loss of purchasing power in the past).

Simple example:

Savings Deposit offering 10% interest rate. Inflation rate (future) would be 20%.

Although we are 10% richer (in nominal terms) next year, we would buy less 10%of goods (to be correct is less 8,33%).

So I guess, we can say, the lower the real interest rate the higher is the incentive to avoid saving (consume). Because, and this is the main point: TO SAVE IS TO DELAY CONSUMPTION.

But at the opposite side of the coin, we have Investment.

And if we follow the same logic, the lower is the real interest rate, the higher is the incentive to Invest.

But we would be wrong (at least partially). The goal of investing is to achieve the highest possible return.

And the evolution of returns does not follow the inflation rate. That’s the main difference.

Another example.

Imagine you borrowed at 10%.

Inflation would be 20%.

Therefore we shall have a -8.33% real interest rate and therefore an incentive to invest. Right? Wrong.

Why is it wrong this time? Because nobody invests in CPI baskets.

Imagine you invested in iron, which had a 30% increase in prices. You should use iron inflation to deflate the nominal interest rate. This would lead to high incentive to invest.

Imagine you invested in oil, which had a 30% decrease in prices. You should use oil inflation to deflate the nominal interest rate. This would lead to low incentive to invest.

(Things could get really tricky, but I dont want to go that way)

Imagine you borrowed at 5% to buy something that increased its price at 10% and your income increased 5%.

Well, what really matters is nominal income growth then? Hurray for the Market Monetarists and most particularly to Geoge Selgin? (future post).

Maybe.

All that really matters is that we really should know what a real interest rate really is.

Enough for today.