Answer:
The real interest rate equals nominal interest rates minus the inflation rate.
Explanation:
Interest rate simply refers to a proportion of the borrowed money that is charged to the borrower.
- So, in an ideal situation with zero inflation, if a borrower gets $100 with a nominal interest rate of 10%, he should pay $10 in interests by the end of the period, so the lender will get his $100 back, plus $10, or 10% of the money borrowed. He ended up with a higher monetary value, having used a real interest rate of 10%.
[tex]Real Interest = NominalInterest-Inflation Rate\\Real Interest = 10percent-0\\Real Interest = 10percent[/tex]
- Let's now say that the inflation rate is 10%. The borrower gets $100 with a nominal interest rate of 10% and an inflation rate of 10%. In this case, he should still pay $10 in interests by the end of the period. The lender will get his $100 back, plus $10 of interests, and even so, he will still end up with the same monetary value as before! He won't be able to buy any more things with $110 now than he was able to buy with $100 before, so his real return was 0%.
[tex]Real Interest = NominalInterest-Inflation Rate\\Real Interest = 10percent-10percent\\Real Interest =0[/tex]
- This happens because when there is an inflation rate of 10%, the monetary value of $100 equals the monetary value of $110 at the end of the period, so you actually need more money to compensate.
- Now, let's say the nominal interest rate is 10%, with an inflation rate of 5%. The borrower would have to pay $10 in interests, so the lender gets his $100 back, plus $10. Since the value of $100 of before equals $105 in the present, and he got $110, he gained some monetary value, but how much? We determine his return with the real interest rate:
[tex]Real Interest = NominalInterest-Inflation Rate\\Real Interest = 10percent-5percent\\Real Interest =5percent[/tex]
