Real interest rate

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The "real interest rate" is the nominal rate of interest, adjusted for compounding, minus the inflation rate. Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.

1 Explanation of the concept
- 1.1 Risks
- 1.2 Importance in economic theory
2 See also
3 External links

[edit] Explanation of the concept

[edit] Risks

In economics and finance, an individual who loans money for repayment at a later point in time expects to be compensated for the time value of money, or not having the use of that money while it is loaned. In addition, they will want to be compensated for the risks of having less purchasing power when the loan is repaid. These risks are systematic risks, regulatory risks and inflation risks. The first includes the possibility that the borrower will default or be unable to pay on the originally agreed upon terms, or that collateral backing the loan will prove to be less valuable than estimated. The second includes taxation and changes in the law which would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than originally estimated. The third takes into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent, that is inflation, and may include fluctuations in the value of the currencies involved.

Nominal interest rates include all three risk factors, plus the time value of the money itself. Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money. Real rates = Nominal rates minus Inflation and Currency adjustment. The "real interest rate" in an economy is often the rate of return on a risk free investment, such as US Treasury notes, minus an index of inflation, such as the CPI, or GDP deflator.

For example, if somebody lends $1000 for a year at 10 percent, and receives $1100 back at the end of the year, this represents a 10 percent increase in his purchasing power if prices for the average goods and services that he buys are unchanged from what they were at the beginning of the year. However, if the prices of the food, clothing, housing, and other things that he wishes to purchase have increased 20 percent over this period, he has in fact suffered a real loss of about 10 percent in his purchasing power.

The inflation rate will not be known in advance. People often base their expectation of future inflation on an average of inflation rates in the past, but this gives rise to errors. The real interest rate ex post may turn out to be quite different from the real interest rate that was expected in advance. Borrowers hope to repay in cheaper money in the future, while lenders hope to collect on more expensive money. When inflation and currency risks are underestimated by lenders, then they will suffer a net reduction in buying power, when inflation and currency risks are over-estimated by borrowers, they will suffer a net reduction in buying power.

The complexity increases for bonds issued for a long term, where the average inflation rate over the term of the loan may be subject to a great deal of uncertainty. In response to this, many governments have issued real return bonds (also known as inflation indexed, in which the principle value and coupon rises each year with the rate of inflation, with the result that the interest rate on the bond is a real interest rate.

The expected real interest rate can vary considerably from year to year. The real interest rate on short term loans is strongly influenced by the monetary policy of central banks. The real interest rate on longer term bonds tends to be more market driven, and in recent decades, with globalized financial markets, the real interest rates in the industrialized countries have become increasingly correlated. Real interest rates have been low by historical standards since 2000, due to a combination of factors, including relatively weak demand for loans by corporations, plus strong savings in newly industrializing countries in Asia. The latter has offset the large borrowing demands by the US Federal Government, which might otherwise have put more upward pressure on real interest rates.

Related is the concept of "risk adjusted return", which is the rate of return minus the risks as measured against the least risk investment available. Thus if a loan is made at 15% with an inflation rate of 5% and 10% in risks associated with default or problems repaying, then the "risk adjusted" rate of return on the investment is 0%.

[edit] Importance in economic theory

Economics relies on measurable variables, chiefly price and objectively measurable production. Since production is "real", while prices are relative to the general price level, in order to compare an economy at two points in time, nominal price variables must be converted into "real" variables. For example, the number of people on payrolls represents a "real" variable, as does the number of hours worked. But in order to measure productivity, the nominal prices of the goods and services that labor produces must be converted to the "real" purchasing power. To do this requires adjusting prices for inflation.

The same is true of investment. Investment produces real gains in efficiency, and purchases productive capacity - factories, machines and so on - which is also real. To find the return on this capital, it is necessary to subtract the increases in its nominal value that are the result of increases in the general level of prices. To do this means subtracting the inflation rate from the nominal rate of return. For example, a portfolio of stocks that returns 10%, when inflation is running at 4% has a 6% rate of return.

The real interest rate is used in various economic theories to explain such phenomena as the business cycle and fluctuations in the stock market. When the real rate of interest is high, that us demand for credit is high, then money will, all other things being equal, move from consumption to savings. Conversely, when the real rate of interest is low, demand will move from savings, to investment and consumption. Different economic theories, beginning with the work of Knut Wicksell have had different explanations of the effect of rising and falling real interest rates.

Related to this concept is the idea of a "natural rate of interest", that is, the expected return on savings and capital invested.