In order to understand how to calculate real interest rate, it is essential first to understand the difference between nominal and real interest rates. Nominal interest rate is the amount of money you earn on your investment, while real interest rate takes inflation into account.
Inflation is a rise in prices that occurs when the supply of goods and services fails to meet the demand. It can be measured by looking at the Consumer Price Index (CPI).
To learn how to calculate real interest rate, keep reading!
Key Points
- What Is Real Interest Rate
- How to Calculate It
- Real vs. Nominal Interest Rates
- How and When to Use Real Interest Rates
- Out Takeaway
What Is Real Interest Rate
The real interest rate is the nominal interest rate minus the inflation rate. It measures how much purchasing power you will have in the future after considering how prices are expected to change.
How to Calculate Real Interest Rate: The Fisher Equation
There are a few different ways to calculate real interest rate. The most common way is known as the Fisher equation. Here’s that real interest rate formula:
Real Interest Rate = Nominal Interest Rate – Inflation Rate
If you have a savings account that pays five percent interest and inflation is two percent, your real interest rate would be three percent (five percent minus two percent). This means that the purchasing power of your money will increase by three percent over the course of one year.
The real interest rate equation can also be used to calculate how much prices will rise in the future. For example, if you expect inflation to be four percent next year, and your nominal interest rate is six percent, your real interest rate would be two percent (six percent minus four percent).
Real vs. Nominal Interest Rates: Example of Calculating Real Interest Rate Using Nominal Interest Rate and Inflation
How do you use the nominal interest rate to calculate real interest rate? Let’s learn through an example.
For example, suppose you have $100 in a savings account that pays a nominal interest rate of 12% per year. If the inflation rate is also 12%, then your real interest rate is 0%. This means that, although you are earning money on your investment, your purchasing power will not change over time. In order to maintain your standard of living, you would need to reinvest your earnings at the same rate as inflation.
If the inflation rate is higher than the nominal interest rate, the real interest rate will be negative. This means that you will lose purchasing power over time, as prices rise faster than your investment earns interest.
For example, if the inflation rate is 15% and your nominal interest rate is only 12%. Using the formula for real interest rate will show a drop of 3%. This means that you would need to reinvest $3 to maintain your standard of living.
How and When to Use Real Interest Rates
Now that you know how to calculate real interest rate, you may wonder how and when to use them. Central banks, businesses, and investors most commonly use real interest rates.
Central banks use real interest rates to make decisions about monetary policy. For example, if the inflation rate is higher than the real interest rate, then this means that prices are rising faster than the economy is growing. In order to slow down inflation, the central bank may raise interest rates.
Businesses also use real interest rate calculator when making investment decisions. A company may decide to invest in a new factory if the real interest rate is positive (meaning that prices are expected to rise). However, if the real interest rate is negative (the prices are expected to fall), the business may decide to wait until the real interest rate becomes positive again—this is why it’s important to monitor the economic cycles.
Investors use real interest rates when deciding how to allocate their money. For example, an investor might choose to invest in a bond if the real interest rate is high (meaning that prices are expected to rise). Alternatively, the investor might decide to invest in stocks if the real interest rate is low (meaning that prices are expected to fall).
How to Calculate Real Interest Rate: Our Takeaway
Interest rates are an essential part of our economy and our lives. By understanding how to calculate real interest rate, we can make more informed decisions about our finances.
While It’s not easy, knowing how to find real interest rate is worth taking the time to learn and implement when organizing your finances—personal or business.