What is real interest Rate?
This is the interest rate excluding inflation rate. In simple
term the real interest is calculated by subtracting the inflation rate from
money. However, mathematically this relationship is slightly different and
explained in the below example.
How real interest rate is calculated
The real
interest rate is calculated by dividing the money rate with inflation rate and
this expression can be expressed mathematically as under
Real
Interest Rate = (1+Money Rate) / (1+
inflation Rate)-1
Example of Real Interest Rate
Money rate
prevailing in the market is 12% while general inflation in the country is 6%.
Calculate the real interest rate.
Solution
|
Money Rate
|
12%
|
|
Inflation Rate
|
6%
|
|
Real Rate (1.12)/(1.06)-1
|
5.66%
|
|
|
|
It is to be noted
that interest rate is slightly lower than figure obtained by subtracting
inflation rate from money rate because mathematically money rate is divided by
inflation rate.
What is purpose of calculating real
interest rate?
The main purpose of calculating the real interest rate is
determine the real return on investment and this information really helps in
investment decisions. The investment must offer a reasonable real interest
rate. The share holder wealth will grow with real interest rate and not with
the money rate. The other important purpose is that present value of discounted
cash flow can only be determined with the real interest rate.
