Macroeconomics

nominal interest rate

is the interest rate as usually reported: it is the rate of

interest that investors pay to borrow money. The real interest rate is the

nominal interest rate corrected for the effects of inflation. If the nominal

interest rate is 8 percent and the inflation rate is 3 percent, then the real inter-

est rate is 5 percent. In Chapter 4 we discuss the relation between nominal

and real interest rates in detail. Here it is sufficient to note that the real inter-

est rate measures the true cost of borrowing and, thus, determines the quan-

tity of investment.

We can summarize this discussion with an equation relating investment I to

the real interest rate r:

I

= I(r).

Figure 3-7 shows this investment function. It slopes downward, because as the

interest rate rises, the quantity of investment demanded falls.

C H A P T E R   3

National Income: Where It Comes From and Where It Goes

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