This problem analyzes why investment spending depends on the real interest rate, not the nominal interest rate. To show this, consider a very simple example.
Case 1: There is no inflation. Axel Widget Company has to pay $10,000 in advance to buy a machine. Axel gets it one year later and produces 1,000 widgets with it, and then the machine falls apart and is worthless. Each widget sells for $11. What are the real and nominal rates of return on this machine?
Case 2: There is a 20 percent rate of inflation expected over the year. Axel expects widgets to sell for 20 percent more ($13.20 each).
What are the real and nominal rates of return on the machine?