In a basic Oxford dictionary, the word interest has many meanings. Interest is something that you pay for the money you borrowed for a particular time period. But in the world of commerce it has one simple meaning. When you borrow a loan, you pay it with interest.
To give a real meaning for the real interest rate we first have to understand the nominal interest.
When a person borrows a loan the interest decided there is the nominal interest. The prime
intention of a lender is to increase his value of the money that has been borrowed. We cannot give a constant real interest rate because nominal interest and real interest are interlinked with the
inflation of that nation or country.
Real rate of interest can be calculated by nominal interest rate minus inflation. Real interest rate
differs when nominal interest rate and inflation are not constant. Basically the real rate of interest
depends on inflation.
But it is seen that with time the value of money is decreasing because of inflation. For example, a loan borrowed at 5% nominal interest is reduced to 2% due to inflation,
now the real interest will be nominal interest rate minus inflation.
The real interest stands at 3%. Higher the inflation lower the real interest rate and lower the inflation higher the real interest rate. Basically real interest rate gives a clearer and correct image of what would a person yield after a particular investment and it also helps a borrower how much he has to bear when he borrows. This helps a borrower to decide when to return back. The investor can decide where to invest with lesser
casualty of risks.
Real rates tell a person what actually he can make of market capital. If the real rate is higher than zero or if it’s positive, the amount paid back is very worthy than the amount borrowed. And if the real interest rate is less than zero or if it’s negative the amount paid back isn’t as worth as the amount borrowed. Here the situation is opposite when money is lent. It is generally observed that in an economy where the real rate of interest is low, more are borrowers less are lenders.
To calculate real interest rate the formula is
1+ i= (1+r) (1+π subscript e)
Where i= nominal interest rate
r= real interest rate
π subscript e = expected inflation rate
This equation is known as fisher’s equation. It provides a link between nominal interest rate and real interest rate. The inflation may be calculated or expected. To put in better words Fisher’s equation describes the relationship between nominal interest rate and real interest rate under the effect of inflation. This equation is widely used in the field of economics and finance