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Chapter 12: Problem 2

Why are international investors especially concerned about the real interest rate as opposed to the nominal rate?

Short Answer

Expert verified
International investors are especially concerned about the real interest rate because it reflects the true profitability or cost of an investment, considering changes in purchasing power due to inflation. This helps them make better-informed investment decisions.

Step by step solution

01

Clarify Nominal Interest Rate

The nominal interest rate is the interest rate as stated in the loan or savings agreement without considering the effect of inflation. It’s the simplest form of interest rate that lenders and investors use for calculations involving interest. If, for instance, you have a savings account that earns an annual interest of 5%, that would be your nominal rate.
02

Understand Real Interest Rate

The real interest rate adjusts the nominal interest rate to remove the effects of inflation and show the real cost of borrowing or real return on saving. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. So, if your savings account has an annual interest of 5%, as in the previous step, and the inflation rate is 2%, then the real interest rate earned is 3%.
03

Apply Understanding to International Investors

International investors are primarily concerned with the real interest rate because it reflects the true earning or the real cost of borrowing, taking into account the changes in purchasing power due to inflation. In other words, the real interest rate gives more precise information about how much an investment will actually yield in terms of purchasing power. It allows the investor to evaluate the potential profit of an investment in real, spendable terms, making it an essential tool for making informed investment decisions in different markets.

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Most popular questions from this chapter

What is meant by exchange rate overshooting? Why does it occur?

Suppose that the nominal interest rate on threemonth Treasury bills is 8 percent in the United States and 6 percent in the United Kingdom, and the rate of inflation is 10 percent in the United States and 4 percent in the United Kingdom. a. What is the real interest rate in each nation? b. In which direction would international investment flow in response to these real interest rates? c. What impact would these investment flows have on the dollar's exchange value?

Suppose that the dollar/franc exchange rate equals \(\$ 0.50\) per franc. According to the purchasing- power-parity theory, what will happen to the dol- lar's exchange value under each of the following circumstances? a. The U.S. price level increases by 10 percent and the price level in Switzerland stays constant. b. The U.S. price level increases by 10 percent and the price level in Switzerland increases by 20 percent. c. The U.S. price level decreases by 10 percent and the price level in Switzerland increases by 5 percent. d. The U.S. price level decreases by 10 percent and the price level in Switzerland decreases by 15 percent.

Explain how the following factors affect the dollar's exchange rate under a system of market-determined exchange rates: (a) a rise in the U.S. price level, with the foreign price level held constant; (b) tariffs and quotas placed on U.S. imports; (c) increased demand for U.S. exports and decreased U.S. demand for imports; (d) rising productivity in the United States relative to other countries; (e) rising real interest rates overseas, relative to U.S. rates; (f) an increase in U.S. money growth; and (g) an increase in U.S. money demand.

What predictions does the purchasing-powerparity theory make concerning the impact of domestic inflation on the home country's exchange rate? What are some limitations of the purchasingpower-parity theory?
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