Real Interest Rate Flashcards, test questions and answers

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What is Real Interest Rate?

The real interest rate is a measure of the cost of borrowing that reflects the purchasing power of money. It is an important economic concept because it helps to determine the level of investment and consumption in an economy, as well as its long-term growth potential. In other words, changes in the real interest rate affect how much businesses choose to invest and how much consumers are willing to spend. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. The nominal interest rate is what banks actually charge for loans; this includes both a risk component and an expected return component. The inflation rate represents how quickly prices are rising, which in turn affects wages and income. When you subtract one from the other, you get a more accurate picture of what people are really paying for borrowing money over time – that’s the real interest rate. For example, imagine that a bank charges 5% on a loan but inflation is 2%. That leaves us with a real interest rate of 3%, meaning that people who borrow money will only see their purchasing power increase by 3%. This could have serious implications for consumer spending if rates stay too low for too long; if people don’t feel like they can make significant gains from investing their cash, then they may be less likely to do so and consumer demand could suffer as a result. On the other hand, when rates are high it encourages investment leading to higher levels of economic growth over time. In short, understanding how changes in real interest rates can affect economic activity can help investors make better decisions about where to put their money and help policymakers craft policies that encourage sustainable growth over time.