Real Interest Rate

Definition

The real interest rate is the interest rate adjusted for the effects of inflation. It represents the true cost of borrowing or lending money, taking into account the purchasing power of the currency over time. The real interest rate is a crucial factor in understanding how the U.S. and other countries experience inflation.

5 Must Know Facts For Your Next Test

1. The real interest rate is calculated by subtracting the expected inflation rate from the nominal interest rate.
2. A positive real interest rate means the purchasing power of the lender's money will increase, while a negative real interest rate indicates a decline in the lender's purchasing power.
3. The real interest rate influences investment and savings decisions, as individuals and businesses seek to maximize their real returns.
4. Central banks often use the real interest rate as a tool to control inflation by adjusting the nominal interest rate to maintain a desired level of real interest rate.
5. The real interest rate can be used to compare the cost of borrowing or the return on investment across different countries or time periods, accounting for differences in inflation rates.

Review Questions

• Explain how the real interest rate is calculated and how it differs from the nominal interest rate.
  • The real interest rate is calculated by subtracting the expected inflation rate from the nominal interest rate. This adjustment is necessary because the nominal interest rate does not account for the erosion of purchasing power due to inflation. The real interest rate represents the true cost of borrowing or the true return on lending, as it considers the effects of inflation on the value of the currency over time. Unlike the nominal interest rate, the real interest rate provides a more accurate measure of the purchasing power of the money involved in the transaction.
• Describe the relationship between the real interest rate, inflation, and investment/savings decisions.
  • The real interest rate is a crucial factor in investment and savings decisions. A positive real interest rate means the purchasing power of the lender's money will increase, providing an incentive to save and lend. Conversely, a negative real interest rate indicates a decline in the lender's purchasing power, discouraging saving and lending. Businesses and individuals seek to maximize their real returns, so the real interest rate influences their decisions to invest or save. Central banks often use the real interest rate as a tool to control inflation by adjusting the nominal interest rate to maintain a desired level of real interest rate.
• Analyze how the real interest rate can be used to compare the cost of borrowing or the return on investment across different countries or time periods.
  • The real interest rate is a useful metric for comparing the cost of borrowing or the return on investment across different countries or time periods because it accounts for differences in inflation rates. By adjusting the nominal interest rate to reflect the true purchasing power of the currency, the real interest rate provides a more accurate basis for comparison. This is particularly important when analyzing investment opportunities or the relative cost of capital in different economic environments, where inflation rates may vary significantly. Using the real interest rate allows for a more meaningful evaluation of the real costs and returns, enabling better-informed financial decisions.

Related terms

Nominal Interest Rate: The stated interest rate before adjusting for inflation. The nominal interest rate does not account for the erosion of purchasing power due to inflation.

Inflation:

The sustained increase in the general price level of goods and services in an economy over time, resulting in a decline in the purchasing power of the currency.

Fisher Effect: The relationship between the nominal interest rate, the real interest rate, and the expected rate of inflation, as described by the economist Irving Fisher.