# What is Real Interest Rate?

Real interest rate is equal to the nominal interest rate (for an investment or loan) minus the inflation rate.

It is a way of calculating interest and adjusting it to account for the economic effects of inflation. factoring in inflation allows you to keep track of the purchasing power of a specific amount of capital constant.

For example, if an investor is going to receive a 3% interest rate for their investments over the next year and there is going to be a 1% rise in prices (inflation), then the real interest rate he or she would receive would be 2%.

*The real interest rate is lower than the nominal interest rate, unless there is deflation.*

It is important to note when using real interest rates that inflation can differ depending on the country and that it can also change significantly during a fiscal year.

Interest rates tend to be greater when the inflation rate is high, and lower when prices rise less (or not at all).

Therefore, real interest rate is a more accurate depiction of the stability of an economy compared to the nominal interest rate.

*ft.com/lexicon* says real interest rate is:

“The actual interest rate (the nominal interest rate) minus the inflation rate. Real interest rates are considered when any monetary transaction has time factored in – for example you lend money to someone for a year and ask to be repaid the principal plus interest of 5 per cent.”

**The Fisher equation:**

The relationship between real interest rate, nominal interest rate and the predicted inflation rate is represented by the Fisher equation:

*1+i = (1+r) (1+π ^{e})*

where:

i = nominal interest rate;

r = real interest rate;

π = expected inflation rate.

**Real interest rates, savings and consumption**

When real interest rates are high, money tends to move from consumption to savings. However, when real interest rates are low, demand will shift from savings to investment and consumption.

**Video – Real Interest Rate**