Interest rates are crucial for understanding the economy, but they are often misunderstood. They should reflect not only inflation, but also innovation, which can lower the cost and time of production. This article explains how to calculate interest rates that account for both inflation and innovation, and why this matters for economic growth and human progress.

Let’s start with a little riddle. Milton is earning $20 an hour and pizzas cost $20, so Milton can buy one pizza for an hour of his time. Milton has worked for an hour and earned $20 but isn’t hungry right now. However, his friend Paul is hungry and offered to pay Milton 5 percent interest on a $20 pizza loan. How much interest will Milton earn when the loan comes due?

Should Paul pay Milton $21? That would be $20 for the principal and $1 for the interest. If there was no inflation and no innovation, Milton would earn 5 percent interest.

But what if inflation has increased the pizza price to $22? If Paul paid back $21, instead of earning 5 percent, Milton would be losing 4.5 percent. If money is purchasing power, shouldn’t Paul pay Milton $23.10? That would be $22 to replace the purchasing power and $1.10 for the interest.

Economists try to make the distinction between the nominal interest rate and the “real” interest rate with the following identity equation:

Nominal interest rate = Real interest rate + Rate of inflation

What if Milton bought the pizza and then loaned the pizza to Paul? Shouldn’t Paul pay back one pizza plus an additional 5 percent slice to cover the interest? (This is what my Muslim friends in Saudi Arabia do to avoid the forbidden “haram” of interest.)

But what if innovation has reduced the price to only $18? Would it be fair for Paul to pay Milton $21? If Paul paid back $21, wouldn’t he really be paying 16.7 percent interest instead of 5 percent ($3 divided by $18)? Shouldn’t Paul pay back $18.90? That would be $18 to replace the purchasing power and $0.90 for the interest.

Note that an economy can experience both inflation and innovation at the same time. Growth in monetary inflation can be offset by innovation. Calculating rates of return should take into consideration many things, including the purchasing power of time; the opportunity cost of that purchasing power when it has been converted to money; monetary inflation; and innovation. Interest rates should reflect both inflation and innovation. Therefore, a more descriptive equation should be:

Nominal interest rate = Real interest rate + Rate of inflation – Rate of innovation

The Time Value of Knowledge

We can measure innovation with time. We buy things with money, but we pay for them with our time. This means there are two prices: money prices and time prices. Money prices are expressed in dollars and cents while time prices are expressed in hours and minutes. Conve