Real interest rate

Inflation-Indexed Government Bond Yield

Taylor Rule Prescriptions for Fed Funds Rate 2016

Real interest rate refers to the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It is the rate of interest above the inflation rate, making it the return on investment in real terms. The real interest rate is adjusted to remove the effects of inflation and gives the lender or investor a clearer idea of the real purchasing power of the money they will receive in the future. Unlike the nominal interest rate, which indicates the rate before taking inflation into account, the real interest rate provides a more accurate measure of the profitability or cost of financial transactions.

Calculation

The real interest rate can be calculated using the Fisher equation, named after economist Irving Fisher. The equation is as follows:

\[Real\ Interest\ Rate = \frac{1 + Nominal\ Interest\ Rate}{1 + Inflation\ Rate} - 1\]

This formula helps in understanding how the real interest rate is directly influenced by the nominal interest rate and the inflation rate. A higher inflation rate decreases the real interest rate, assuming the nominal interest rate remains constant.

Importance

The real interest rate is crucial for both investors and borrowers. For investors, it helps in determining the real return on their investments. For borrowers, it shows the real cost of their loans. Central banks also monitor real interest rates closely as they make decisions regarding monetary policy to control inflation and stabilize the economy.

Impact on Economy

Real interest rates have a significant impact on the economy. They influence consumer spending, investment, and the overall economic growth. High real interest rates can lead to lower levels of borrowing and spending, which in turn can slow economic growth. Conversely, low real interest rates may encourage borrowing and investing but can also lead to inflation if the economy overheats.

See Also

• Inflation
• Nominal interest rate
• Monetary policy
• Economic growth