Real interest rate

Real interest rate is the interest rate adjusted for inflation, reflecting the true cost of borrowing and the real yield on investments.
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Updated: Jun 14, 2024

3 key takeaways

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  • Real interest rate accounts for inflation, offering a more accurate measure of the true cost of borrowing and the real return on savings and investments.
  • It is calculated by subtracting the inflation rate from the nominal interest rate.
  • Real interest rates provide insight into the economic environment, influencing consumer and business decisions on spending, saving, and investing.

What is real interest rate?

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The real interest rate is the interest rate that has been adjusted for inflation, providing a clearer picture of the actual cost of borrowing and the real yield on savings and investments.

Unlike the nominal interest rate, which is the stated rate without adjustments, the real interest rate reflects the true value of interest payments after considering the erosion of purchasing power due to inflation.

Importance of real interest rate

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Real interest rates are crucial for several reasons. They offer a more accurate measure of the economic incentives for borrowing and lending. For borrowers, the real interest rate indicates the true cost of loans after accounting for inflation.

For savers and investors, it shows the actual return on their investments, providing a better basis for financial planning and decision-making.

Calculating real interest rate

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To calculate the real interest rate, the following formula is used: Real Interest Rate = Nominal Interest Rate – Inflation Rate

This formula adjusts the nominal interest rate by subtracting the inflation rate, yielding the real interest rate that accurately reflects the true cost or return.

Factors affecting real interest rates

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Several factors can influence real interest rates, including:

  • Inflation expectations: Higher expected inflation generally leads to higher nominal interest rates to compensate lenders for the loss of purchasing power.
  • Economic growth: Strong economic growth can lead to higher real interest rates due to increased demand for capital and investment opportunities.
  • Monetary policy: Central banks influence real interest rates through their monetary policy decisions, such as setting benchmark interest rates and conducting open market operations.
  • Supply and demand for credit: The balance between the supply of savings and the demand for loans can affect real interest rates. Higher demand for credit can push up real interest rates, while an abundance of savings can lower them.

Example of real interest rate

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Suppose the nominal interest rate on a savings account is 5%, and the inflation rate is 2%. The real interest rate can be calculated as follows: Real Interest Rate = 5% – 2% = 3%

This means that, after adjusting for inflation, the real return on the savings account is 3%, providing a clearer picture of the true earning potential of the investment.

Impact of real interest rates

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Real interest rates have a significant impact on various economic activities:

  • Borrowing and lending: Higher real interest rates can discourage borrowing and reduce consumer spending and business investments. Conversely, lower real interest rates can stimulate borrowing, spending, and investment.
  • Saving and investing: Real interest rates influence the attractiveness of saving versus spending. Higher real interest rates provide greater incentives for saving, while lower real interest rates may encourage consumption and investment in riskier assets.
  • Inflation control: Central banks monitor real interest rates as part of their efforts to control inflation and stabilize the economy. Adjusting nominal interest rates can help manage inflationary pressures and maintain economic stability.

Understanding real interest rates is essential for making informed financial decisions, assessing the economic environment, and planning for future financial needs.

By considering inflation, real interest rates provide a more accurate measure of the true cost and return on borrowing and investing activities.



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Arti
AI Financial Assistant
Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.