What Is the Real Rate of Interest?
The real rate of interest is the rate of interest that investors require after accounting for inflation. It is the nominal rate of interest adjusted to remove the effects of inflation. This rate gives a true reflection of the cost of borrowing and the return on investment by showing the rate at which the purchasing power of the principal increases or decreases over time.
Formula
The real rate of interest (r) can be calculated using the following formula:
\[ r = i - \pi \]
Where:
- \( r \) = Real rate of interest
- \( i \) = Nominal rate of interest
- \( \pi \) = Inflation rate
Alternatively, more precisely with the Fisher equation:
\[ 1 + r = \frac{1 + i}{1 + \pi} \]
Examples
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Example 1: Simple Calculation
- If the nominal interest rate (i) on a loan is 8% and the inflation rate (\(\pi\)) is 2%, the real rate of interest (r) is calculated as: \[ r = 8% - 2% = 6% \]
-
Example 2: With Fisher Equation
- If the nominal interest rate (i) is 10% and the inflation rate (\(\pi\)) is 4%, the real rate of interest (r) can be more accurately calculated using the Fisher equation: \[ 1 + r = \frac{1 + 0.10}{1 + 0.04} \] \[ 1 + r = 1.10 / 1.04 \approx 1.0577 \] \[ r \approx 1.0577 - 1 = 0.0577 \text{ or } 5.77% \]
Frequently Asked Questions (FAQs)
Q1: Why is the real rate of interest important? A1: The real rate of interest is crucial because it represents the true return on an investment or the true cost of borrowing, accounting for inflation. It helps investors and borrowers make better-informed decisions.
Q2: How does inflation affect the real rate of interest? A2: Inflation reduces the purchasing power of money. When inflation is high, the real rate of interest decreases because the nominal yield is offset by the eroding value of currency.
Q3: Is the real rate of interest always lower than the nominal rate? A3: Generally, yes, the real rate is lower than the nominal rate as it factors out inflation, assuming inflation is positive. In rare deflationary scenarios, the real rate could be higher.
Q4: How does the real rate of interest impact investment decisions? A4: Investors look at the real rate of interest to gauge the actual return on their investments after inflation is considered. A low real rate indicates lower purchasing power growth, potentially discouraging investments.
Q5: What happens to the real rate of interest if inflation expectations change? A5: If inflation expectations increase, the real rate of interest tends to decrease unless the nominal rates are adjusted upward accordingly. Conversely, if inflation expectations fall, the real rate of interest rises, boosting the real cost of borrowing or real investment returns.
Related Terms
- Nominal Interest Rate: The rate of interest before adjusting for inflation.
- Inflation Rate: The annual percentage increase in the general price level of goods and services.
- Fisher Equation: A concept stating that the nominal interest rate is the sum of the real interest rate and the expected inflation rate.
Online References
Suggested Books for Further Studies
- Interest Rates, Prices, and the Economy: A Study of Interest Rates and Financial Markets by C.J. Ball
- A New Guide to Post Keynesian Economics by Mathew Forstater, Gary Mongiovi
- Investments by Zvi Bodie, Alex Kane, and Alan J. Marcus
Accounting Basics: “Real Rate of Interest” Fundamentals Quiz
Thank you for exploring the concept of the real rate of interest and testing your understanding with our quiz. Keep striving for excellence in your financial knowledge!
