If in the same example the nominal interest rate was 5% and the rate of inflation was the same at 3%, it would result in a 2% real interest rate calculation indicating inflation-adjusted returns.
The nominal interest rate in the interest rate before inflation has been accounted for and removed from the number. The real interest rate formula adjusts the nominal interest rate (i), for the effects of inflation (g) to calculate the real interest rate (r).
It shows the extent of the increase or decline in purchasing power. When you borrow or lend, you normally do so in dollar terms. Consumer Price Index (CPI) tracks how inflation impacts the prices of consumer goods in the retail sector and this is usually considered as the benchmark for measuring inflation and is widely used for making calculations where inflation is taken into account. This has been a guide to what is Real Interest Rate and its definition. For instance, if the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them. For calculating this rate as well, CPI figures come in handy and help provide a reliable approximation of what one might actually earn on an investment. Example: If the rate of inflation is at 3%, and the real interest rate is 2%, then the nominal interest rate would be 5%. To continue the example, now imagine that the inflation rate was 5%. If you take out a loan, the loan is denominated in dollars, and your promised payments are denominated in dollars. Calculating the real interest rate involves subtracting the rate of inflation (whether expected or actual) from the more straightforward nominal interest rate (described in more detail below). Real interest rate = nominal interest rate – inflation rate. The nominal interest rate does not take into account any factor which might affect the rate of interest or returns on an investment, including inflation. The basic formula is as follows: Real Interest Rate (R) = Nominal Interest Rate (r) – Rate of Inflation (i) The more precise and mathematical formula is: (1+ (R)) = (1+ (r)) / (1+ (i)) This means that when the rate of inflation is zero, the real interest rate is equal to the nominal interest rate. Solving for real interest rate. Since calculating the real interest rate requires you to know the rate of inflation, it’s important to understand this as well.
The real interest rate is a representation of how much individuals favor current goods rather than goods in the future. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. The calculation of the real interest rate also “deflates” the nominal interest rate.
It approximately equals nominal interest rate minus inflation rate. Home > Discount Rate > Real Interest Rate Formula.
Inflation refers to the decrease in purchasing power of money due to increase in general price level. Based on an idea of how much you might actually earn on a specific investment, viable alternatives can also be explored to achieve the investment objective. This is often described as a range for want of exactness and accurate figures can only be obtained for years passed.