Hi.
Earlier in the Economics syllabus, I was given to understand that ‘Real Interest Rate Parity’ generally holds whereby real interest rates across nations tend to converge to the same level.
Then, in the Chapter- Economic Growth and the Investment Decision, it is said that when potential GDP rises, the real interest rate rises.
How does this add up? Where do we reconcile things?
Thank you guys.
What is your doubt exactly? Do you think that both statements are contradictory or have no relation at all?
Remember that nominal interest rates are real interest rates + risk premiums. So, when we study what drives those risk premiums, we see that they are driven by different variables than real interest rates do.
Real interest rates are driven mainly by macroeconomic factors or industry factors. If we could separate the risky factors for a moment, the minimum required rate of return on any investment would be the real rate of return itself.
Countries develop over time, their industries compete and resources are allocated dynamically (capital and human), so in the long term, countries with similar economies (similar GDP per capita) should have similar real interest rates. At the end, nominal rates could vary because of perceived risk factors (risk premiums added to real rates).
When a country develops a new technology, or apply a big positive reform for example, its potential GDP would increase. Thus making space for new business and higher profits than before (momentarily of course). In that period of time, real interest rates should increase accordingly.
If you have any further doubt, please let me know.
Hope this helps!