In economics and finance, a real interest rate is an interest rate adjusted for inflation. When money is borrowed, the lender generally expects to be compensated for providing this service. The level of compensation typically involves an interest rate, or a fee equal to some percentage of the loan. Inflation, however, tends to reduce to actual value of the borrowed money over time. A real interest rate, therefore, factors in the effects of inflation.
Inflation is a term used to describe the phenomenon of rising prices of goods and services over time. When the prices of goods and services drop with time, it is called deflation. Inflation has some negative effects on the economy, but a majority of economists maintain that a small level of inflation is preferable to any other situation. It can help labor markets adjust rapidly and ease a country’s recovery from an economic recession. For this reason, governments aim to control inflation rates at some optimal level.
While rising prices of goods and services can hurt consumers, inflation can help those who are in debt. The original amount of the debt, which is called the principle, remains constant over time. But the real value, or actual purchasing power, of the loan shrinks over time because of inflation. The money used for a loan of $5,000 US Dollars will be able to buy fewer goods and services after it is returned several years later. One of the reasons lenders charge interest rates is to counter this loss in the value of money.
Lenders charge interest on loans to mitigate several kinds of risks, such as a borrower not returning the money or unforeseen laws emerging. In some cases, like government Treasury bonds, many people ignore these risks as negligible. In these “safe” situations, inflation is the primary factor in the difference between real and nominal, or regular, interest rates. The Fisher equation is used by economists in more complicated real interest rate calculations.
A real interest rate in a simplified scenario would be equal to the nominal interest rate minus the inflation rate. Both inflation rates and interest rates typically refer to annual rates. If a government Treasury bond states that it will pay an interest rate of 5% and the inflation rate remains at 2%, the real interest rate is 5–2=3%. That is, the real rate of return, or rate of return judged by the ability to buy actual goods and services, is 3% and not 5%.