What Are Real Interest Rates?
- The Fisher Equation is the basic equation that calculates real interest rates. It says that the real interest rate is equal to the nominal interest rate minus inflation. Since inflation is positive, the nominal interest rate is larger than the real interest rate. In rare cases where deflation or negative inflation happens, the nominal interest rate can sometimes be smaller than the real interest rate.
- On its simplest terms, inflation can be defined as the gradual and overall increase of prices of services and commodities in an economy. As prices increase in time, the value of money decreases since you may need more money in order to buy a product. Since this is the case, the money in your bank that you have deposited a year ago may have lower buying power because of inflation.
- Nominal interest rate can be defined as the rate of interest without taking inflation into account. Since inflation is not accounted for, you can have a high nominal interest rate and may think that you have earned a lot of money in your investment. Depending on the rate of inflation, your real return may even be negative even if your nominal interest rate is positive.
- As defined earlier, the real interest rate is the actual amount that your investment produced in a certain period of time. Since it takes inflation into account, this is the "real" worth of your investment. For example, you have deposited $100 last year with a nominal rate of 5%, which means you will get $105 this year. That is the nominal interest rate of your investment since you have not considered the inflation rate. Now let's say that last year a mobile phone costs around $100, and because of inflation this year it costs $105. If you consider the inflation that means that your money didn't actually gain any positive interest since you are buying the mobile phone for $105 this year. If a mobile phone now costs $110, this means that your real interest rate is actually negative, since the nominal interest rate didn't keep up with the pace of inflation.
- For most investors, it may seem that inflation has a major negative effect on their investments; however, negative inflation or deflation can drastically effect an economy and it is also one of the proofs that a country's economy is in recession. Deflation discourages buying and investment, which will lead to unemployment since the products being sold are not being bought by consumers. To counter the problem of too much supply, products are going to be produced less and less and the manpower needed to produce this product will also be less. In a healthy economy, it is normal that the real interest rate is lower than the nominal interest rate.
