What is Real Interest Rate?
472 reads · Last updated: December 5, 2024
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).
Definition
The real interest rate is an interest rate that has been adjusted to remove the effects of inflation. After adjustment, it reflects the true cost of funds for borrowers and the real yield for lenders or investors. The real interest rate indicates the time preference rate for current goods over 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 originated from economic studies on the impact of inflation. As early as the early 20th century, economists began to focus on how inflation affects interest rates. The Fisher Effect, proposed by economist Irving Fisher in the 1930s, highlights the relationship between nominal and real interest rates, stating that the nominal rate equals the real rate plus the inflation rate.
Categories and Features
Real interest rates can be categorized into positive and negative real interest rates. A positive real interest rate means that investors can earn returns after accounting for inflation, while a negative real interest rate indicates that inflation erodes the investor's returns. The feature of real interest rates is their ability to accurately reflect the time value of money, aiding investors and borrowers in making more informed financial decisions.
Case Studies
A typical case is the United States in the 1970s, where high inflation due to the oil crisis led to high nominal rates, but real rates were low or even negative, eroding investors' real returns. Another case is post-2008 financial crisis, where the Federal Reserve lowered nominal rates to near zero to stimulate the economy, but with low inflation, real rates remained positive, encouraging investment and consumption.
Common Issues
Investors often misunderstand the difference between nominal and real interest rates, overlooking the impact of inflation, which can lead to overestimating investment returns. Additionally, calculating real interest rates requires accurate inflation expectations, and incorrect forecasts can result in poor financial decisions.
