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Real Interest Rate
> Introduction to Real Interest Rate

### What is the concept of real interest rate and how does it differ from nominal interest rate?

The concept of real interest rate is a fundamental concept in economics that plays a crucial role in understanding the dynamics of financial markets and the overall economy. It represents the true cost of borrowing or the return on lending after accounting for the effects of inflation. In contrast, the nominal interest rate is the stated interest rate without adjusting for inflation.

The nominal interest rate is the rate that is typically quoted by banks, financial institutions, and central banks. It is the rate at which borrowers can obtain funds and lenders can earn returns on their investments. For example, if a bank offers a loan with a nominal interest rate of 5%, it means that borrowers will have to pay back the loan amount plus an additional 5% as interest.

However, the nominal interest rate does not take into account the impact of inflation. Inflation refers to the general increase in prices of goods and services over time. When inflation occurs, the purchasing power of money decreases, meaning that the same amount of money can buy fewer goods and services. Therefore, if the nominal interest rate does not adjust for inflation, it may not accurately reflect the true cost of borrowing or the return on lending.

To understand the true cost of borrowing or the return on lending, economists use the concept of real interest rate. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. It represents the rate at which the purchasing power of money changes over time.

For example, if the nominal interest rate is 5% and the inflation rate is 2%, the real interest rate would be 3%. This means that after accounting for inflation, lenders would earn a real return of 3% on their investments, and borrowers would pay a real cost of borrowing of 3%.

The distinction between nominal and real interest rates is essential for several reasons. Firstly, it allows economists and policymakers to analyze and compare interest rates across different time periods or countries with varying inflation rates. By adjusting for inflation, they can assess the true changes in borrowing costs or returns on investments.

Secondly, the real interest rate provides valuable insights into the behavior of savers and investors. When the real interest rate is high, it incentivizes saving and investment as individuals and businesses can earn a higher return on their funds. Conversely, when the real interest rate is low, it may discourage saving and investment as the returns are relatively lower.

Lastly, the real interest rate also influences consumption and borrowing decisions by households and businesses. When the real interest rate is low, borrowing becomes cheaper, leading to increased consumption and investment. On the other hand, when the real interest rate is high, borrowing becomes more expensive, potentially reducing consumption and investment.

In summary, the concept of real interest rate captures the true cost of borrowing or the return on lending after adjusting for inflation. It differs from the nominal interest rate, which does not account for inflation. Understanding the distinction between these two rates is crucial for analyzing financial markets, making investment decisions, and formulating effective monetary policies.