What is Real Interest Rate?

Real interest rate is a financial term that refers to the adjusted rate of return on an investment or loan after taking current inflation into account. It is an important factor to consider as it reflects the purchasing power value of the interest amount. In other words, when a lender and borrower agree to a certain interest rate, the real interest rate is a measure that takes into account how much purchasing power the lender or borrower will have to obtain the goods or services that the interest amount can purchase after the inflation has occurred. When it comes to investments, prospective real interest rates are based on the estimated inflation rate over the specific period of the investment.

The real interest rate is calculated by subtracting the inflation rate from the nominal or face interest rate. For example, if a lender loans a borrower $1000 at a nominal interest rate of 5%, and the inflation rate is estimated at 2.5%, the real interest rate would be 2.5%. Real interest rate plays an important role in determining the health of a nation's economy. A negative real interest rate is often indicative that the economy is either experiencing deflation, in which case prices are dropping over time, or spiraling rates of inflation, in which case prices are increasing faster than the nominal rate of return from investments.

The significance of real interest rate can also be gauged from the role it plays for Central Banks. Low real interest rates foster a low cost of borrowing and spending, particularly for businesses. This encourages investments in capital, leading to an overall increase in economic productivity and output. Higher real interest rate on the other hand leads to hoarding of capital and reduced economic activities, owing to increased difficulty in acquiring loans leading to reduced investment in fixed capital.

Real interest rates would also be affected by the macroeconomic policy adopted by a central bank. For example, if the bank decreases the nominal interest rates, then the real interest rate would also be decreased. In such a case, businesses could stimulate investment, leading to better economic output. On the other hand, if a central bank increases the nominal interest rate, then the real interest rate could go up and encourage cost of borrowing for businesses, leading to a decrease in investment.

In conclusion, real interest rate is an important economic indicator that tells us the purchasing power that individuals can enjoy from their savings. It is also an important tool used by central banks to help guide their monetary policies and thus influence the economic activity of a country.