Real Interest Rate: Definition, Formula, and Example
What Is a 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
The real interest rate is a critical concept in economics and finance. It represents the true cost of borrowing or the actual return on investment after accounting for inflation. In other words, it’s the nominal interest rate (the rate you see advertised) minus the rate of inflation.
Mathematically, the real interest rate (r) can be expressed as:
�=Nominal Interest Rate−Inflation Rate
Here’s a breakdown of the terms:
- Nominal Interest Rate: This is the interest rate that is usually advertised or quoted. It represents the percentage increase in the value of a deposit or investment over a given period.
- Inflation Rate: Inflation is the rate at which the general price level of goods and services rises, leading to a decrease in the purchasing power of money. The inflation rate indicates the percentage increase in prices over a specific period.
By subtracting the inflation rate from the nominal interest rate, you arrive at the real interest rate, which provides a more accurate measure of the actual return on an investment or the true cost of borrowing.
The real interest rate is important for several reasons:
- Accurate Comparison: It allows for more accurate comparisons of investment opportunities or borrowing options, as it takes into account the erosion of purchasing power due to inflation.
- Incentive to Save: A positive real interest rate rewards saving because it means your money is growing faster than the rate at which prices are rising.
- Cost of Borrowing: A higher real interest rate makes borrowing more expensive in real terms, potentially leading to reduced borrowing and spending in the economy.
- Economic Policy: Central banks and policymakers consider real interest rates when making decisions about monetary policy, as changes in real interest rates can impact consumption, investment, and economic growth.
- Investment Decision: Investors use the real interest rate to assess whether an investment will provide a return that exceeds the rate of inflation.
It’s worth noting that the real interest rate can be negative if the nominal interest rate is lower than the inflation rate. In this case, even though you’re earning interest on your investment, the value of your money is declining due to inflation.
Overall, understanding the real interest rate helps individuals, businesses, and policymakers make informed financial decisions and assess the true value of money over time.
- A real interest rate equals the observed market interest rate adjusted for the effects of inflation.
- It reflects the purchasing power value of the interest paid on an investment or loan.
- It also represents the rate of time-preference of a borrower and lender.
- Prospective real interest rates rely on estimates of future inflation over the time to maturity of a loan or investment.
- Investors could earn a rate of return that’s negative if the inflation rate is higher than the nominal rate of return on their investments.
Understanding Real Interest Rates
While the nominal interest rate is the interest rate actually paid on a loan or investment, the real interest rate is a reflection of the change in purchasing power derived from an investment or given up by the borrower.
The nominal interest rate is generally the one advertised by the institution backing the loan or investment. Adjusting the nominal interest rate to compensate for the effects of inflation helps to identify the shift in purchasing power of a given level of capital over time.
According to the time-preference theory of interest, the real interest rate reflects the degree to which an individual prefers current goods over future goods.
Borrowers who are eager to enjoy the present use of funds show a stronger time preference for current goods over future goods. They are willing to pay a higher interest rate for loaned funds.
Similarly, a lender who strongly prefers to put off consumption to the future shows a lower time preference and will be willing to loan funds at a lower rate. Adjusting for inflation can help reveal the rate of time preference among market participants.
Expected Rate of Inflation
The expected rate of inflation is reported to Congress by the Federal Reserve (Fed), among others. Reports include estimates for a minimum three-year period. Most expected (or anticipatory) interest rates are reported as ranges instead of single-point estimates.1
As the true rate of inflation may not be known until an investment reaches maturity or its holding period ends, the associated real interest rates must be considered anticipatory.
It’s important that investors bear in mind current and expected inflation rates when they research where to put their money. Since the rate of inflation will eat away at the nominal rate of return, avoid lower returning fixed income investments that could mean a negligible real rate of return.
Effect of Inflation on the Purchasing Power of Investment Gains
In cases where inflation is positive, the real interest rate will be lower than the advertised nominal interest rate.
For example, if an investment such as a certificate of deposit (CD) is set to earn 4% in interest per year and the rate of inflation for the same time period is 3%, the real interest rate earned on the investment will be 1% (4% – 3%). When purchasing power is taken into consideration, the real value of the funds deposited in the CD will only increase by 1% per year, not 4%.
If those funds were instead placed in a savings account with an interest rate of 1%, and the rate of inflation remained at 3%, then the real value, or purchasing power, of the funds in savings will actually decrease. The real interest rate would be -2% after accounting for inflation (1% – 3%).
What Is Purchasing Power?
Purchasing power is the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. It is important because, all else being equal, inflation decreases the number of goods or services you can purchase.
For investments, purchasing power is the dollar amount of credit available to a customer to buy additional securities against the existing marginable securities in the brokerage account. Purchasing power is also known as a currency’s buying power.
What Is Inflation?
Inflation is the decline of purchasing power of a given currency over time. The rate of inflation, or the rate of decline in purchasing power, is reflected by the Consumer Price Index (CPI). CPI measures the change in an average price of a basket of selected goods and services over a specific period of time.
The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods. Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.
How Does a Real Interest Rate Affect Investment Returns?
A real interest rate is the nominal (or stated) interest rate less the rate of inflation. For investments, the inflation rate will erode the value of an investment’s return by decreasing the rate of return.
For example, if the rate of return for bonds you hold is 6% and the inflation rate is 3%, then the real rate of return will be 3%, not 6%. That’s because the interest rate of 6% is adjusted downward by 3% to account for the unfortunate power of inflation to erode value (6% – 3% = 3%).
The Bottom Line
The real interest rate is an interest rate that has been adjusted for inflation to reflect the real cost of funds to a borrower and the real yield to a lender or an investor.
It reflects the rate of time preference for current goods over future goods and is calculated as the difference between the nominal interest rate and the inflation rate.
Prepare and write by:
Author: Mohammed A Bazzoun
If you have any more specific questions, feel free to ask in comments.
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