What Does the Real Interest Rate Tells You

The real interest rate tells you the actual return or cost of borrowing after accounting for inflation. It provides insight into the true purchasing power gained or lost from an investment or loan.

Specifically, the real interest rate = nominal interest rate - inflation rate (see also the Simplified Fisher Equation)

It shows the real return received by a lender or investor after adjusting for inflation's erosion of purchasing power.

A positive real rate means the nominal return exceeds inflation, increasing purchasing power. On the other hand, a negative real rate means inflation is higher than the nominal return, decreasing purchasing power.

The real interest rate matters because:

• It shapes investor and borrower behavior towards risk-taking or conservatism. Low or negative real rates encourage risk-taking to earn higher returns that outpace inflation. High positive real rates incentivize conservative investing/lending since purchasing power rises without risk (more on this below).
• It is a key indicator monitored by central banks like the Federal Reserve when setting monetary policy to achieve price stability and full employment.
• During periods of high and volatile inflation, understanding the real rate is crucial to assess the true return on investments and cost of borrowing.

In essence, the real interest rate reveals whether you are actually gaining or losing purchasing power from the stated nominal interest rate after factoring in inflation's impact.

How Does the Real Interest Rate Affect Borrowing and Saving Decisions

The real interest rate significantly affects borrowing and saving decisions by influencing the incentives and behavior of consumers and businesses:

Borrowing Decisions:

• A high positive real interest rate increases the cost of borrowing, discouraging individuals and businesses from taking on new debt or loans. This dampens spending and investment.
• A low or negative real interest rate reduces the cost of borrowing, incentivizing more debt financing for big purchases like homes, cars, business expansions etc. as the real cost of debt is low or negative after accounting for inflation.

Saving Decisions:

• A high positive real interest rate makes saving more attractive as the real return on savings and investments outpaces inflation, increasing purchasing power over time. This encourages more saving.
• A low or negative real interest rate reduces the incentive to save as the real return is low or negative after inflation, eroding purchasing power. This discourages saving in favor of current consumption or investing in riskier assets that may provide higher returns.

Central banks closely monitor and adjust real interest rates through monetary policy to influence borrowing, saving, investment, and consumption in line with economic objectives like full employment and price stability.

How Do Changes in the Real Interest Rate Impact the Economy

Changes in the real interest rate have significant impacts on the economy by influencing consumption, investment, and borrowing decisions of households and businesses:

Impact on Consumption:

• A higher real interest rate increases the incentive to save as the real return on savings rises, leading to lower consumption spending by households.
• A lower real interest rate reduces the incentive to save as the real return declines, encouraging higher current consumption spending by households.

Impact on Investment

• A higher real interest rate raises the cost of borrowing for investment projects, discouraging businesses from undertaking new investments and expansions. This slows economic growth.
• A lower real interest rate reduces the cost of capital for businesses, stimulating more investment in new projects, facilities, and hiring as the real cost of borrowing declines. This boosts economic growth.

Impact on Exchange Rates and Trade

• A higher real interest rate tends to attract foreign capital inflows, causing the domestic currency to appreciate. This makes exports more expensive and imports cheaper, negatively impacting net exports.
• A lower real interest rate tends to trigger capital outflows, causing the domestic currency to depreciate. This makes exports cheaper and imports more expensive, potentially improving the trade balance.

Related Readings:

1. Has the U.S. Economy Transitioned to a Higher Long-run Real Interest Rate Regime? (Federal Reserve Bank of St. Louis)
2. No One Really Understands Real Interest Rates (Bloomberg)

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