The real interest rate is the nominal interest rate adjusted for inflation. It shows the return to an investor, or the cost to a borrower, measured in goods
156 CHAPTER 11. A MODEL WITH ACTIVE MONETARY POLICY
rather than in money. Consider the purchase of a bond worth the equivalent of one good at the current price, $P. After one year, this investment returns $(1 + i)P. How much does it return measured in goods? The price that the investor expects to prevail in one year is pe +1 = (1 + He)P. Therefore, the return measured in goods, which is the real rate of interest, r, is
approximate the result closely with the standard equation for the real rate of interest, which is known as the Fisher equation in honor of the pioneering work of Irving Fisher :
(11.1) It is the real, rather than the nominal, rate of interest that central banks
are most concerned with, since it affects investment spending when decisionmakers do not suffer from money illusion.