Real Interest Rate
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation. Once adjusted, it reflects the real cost of funds to a borrower and the real yield to a lender or to an investor.A real interest rate reflects the rate of time preference for current goods over future goods. For an investment, a real interest rate is calculated as the difference between the nominal interest rate and the inflation rate:Real interest rate = nominal interest rate - rate of inflation (expected or actual).
Real Interest Rate
Definition
The real interest rate is an interest rate that has been adjusted to remove the effects of inflation. After adjustment, it reflects the actual cost of funds for borrowers and the actual return for lenders or investors. The real interest rate reflects the time preference rate for current goods relative to future goods. For an investment, the real interest rate is calculated as the difference between the nominal interest rate and the inflation rate: Real Interest Rate = Nominal Interest Rate - Inflation Rate (expected or actual).
Origin
The concept of the real interest rate can be traced back to the classical economics period, particularly to 19th-century economists like Irving Fisher. Fisher elaborated on the relationship between nominal and real interest rates in his work 'The Theory of Interest' and proposed the famous Fisher equation: Nominal Interest Rate = Real Interest Rate + Inflation Rate.
Categories and Characteristics
Real interest rates can be divided into two categories: expected real interest rates and actual real interest rates. Expected real interest rates are based on forecasts of future inflation rates, while actual real interest rates are based on the inflation rates that have actually occurred. Expected real interest rates are typically used in investment decisions and economic forecasts, while actual real interest rates are used to evaluate past economic performance.
Specific Cases
Case 1: Suppose an investor buys a one-year fixed deposit with a nominal interest rate of 5%, and the inflation rate for that year is 2%. The investor's real interest rate would be 5% - 2% = 3%. This means that although the nominal return is 5%, the actual return after accounting for inflation is only 3%.
Case 2: A company issues a bond with a nominal interest rate of 6%. If the market expects future inflation to be 4%, the expected real interest rate for investors would be 6% - 4% = 2%. This will affect investors' demand for and pricing of the bond.
Common Questions
1. Why is the real interest rate more important than the nominal interest rate?
The real interest rate better reflects the true cost and return of funds because it takes inflation into account.
2. How can future inflation rates be predicted?
Future inflation rates can be estimated by analyzing economic indicators, market expectations, and expert forecasts.
