Real interest rate

Definition

The real interest rate is the nominal interest rate adjusted for inflation, reflecting the true cost of borrowing and the true yield on savings. It helps borrowers and lenders understand the actual purchasing power of money over time, making it a critical concept when considering the economic effects of inflation and deflation.

5 Must Know Facts For Your Next Test

1. The real interest rate can be calculated using the formula: real interest rate = nominal interest rate - inflation rate.
2. When inflation is higher than the nominal interest rate, the real interest rate becomes negative, meaning borrowers benefit as they repay loans with less valuable dollars.
3. A rising real interest rate can signal a tightening of monetary policy, which may be used to combat inflation but can also slow economic growth.
4. Real interest rates influence consumer behavior, affecting decisions around spending, saving, and investing based on perceived value over time.
5. Changes in real interest rates can impact asset prices; for example, higher real rates often lead to lower bond prices as new bonds are issued at higher yields.

Review Questions

• How does the real interest rate influence borrowing and lending decisions in an economy experiencing high inflation?
  • In an economy facing high inflation, the real interest rate becomes critical as it reflects the actual cost of borrowing. If the nominal interest rate remains low compared to the rising inflation, borrowers may find it advantageous to take out loans since they can repay them with money that has less purchasing power. Conversely, lenders may be hesitant to lend if the real interest rate is low or negative, as their returns diminish in value over time.
• Evaluate how changes in real interest rates can affect overall economic growth during periods of deflation.
  • During periods of deflation, real interest rates typically rise because nominal rates often do not decrease as quickly as prices do. This increase can discourage borrowing because consumers and businesses face higher costs for loans relative to falling prices. As a result, spending may decrease, leading to slower economic growth as investments decline and consumption contracts further due to uncertainty about future income and price levels.
• Assess the broader implications of sustained negative real interest rates on an economy's long-term financial health and stability.
  • Sustained negative real interest rates can lead to several long-term financial challenges for an economy. They can encourage excessive borrowing and risk-taking among consumers and businesses since money is cheap to borrow, potentially resulting in asset bubbles. Additionally, persistent negative rates can erode savings, as savers receive returns that do not keep pace with inflation. Over time, this can undermine financial stability by creating unsustainable debt levels and jeopardizing future economic growth when the necessary corrections occur.

Related terms

nominal interest rate:

The nominal interest rate is the stated interest rate on a loan or investment without adjusting for inflation, representing the raw percentage increase in money over time.

inflation rate: The inflation rate measures how much the general price level of goods and services rises over a period, leading to a decrease in purchasing power.

deflation: Deflation is the reduction of the general price level of goods and services, often leading to increased real value of money and potentially slowing economic growth.