Real Interest Rate Formula

Real Interest Rate Formula

Real interest rate formula has been shown below. Real interest rate formula has been explained with an example

(1+m) = (1+i)(1+r)

Real interest does not incorporate inflation (interest rate exclusive of inflation). The above formula is known as fisher effect.

Re arrange formula

r         = (1+m)   -1

              (1+i)

m=money Interest rate

i= inflation rate in the economy

r= real Interest rate

Real Interest Formula Example

Prevailing Inflation rate in country = 10%

Money Rate in market or country = 14%

Calculate real rate

Solution

r        = (1+m)   -1

              (1+i)

r       = (1+14%) -1

              (1+10%)

=3.63% (Real Rate)

Quick Calculation of Real Interest Rate

Real interest can be roughly calculated by subtracting inflation rate from the money rate. However it is important to remember that such calculated rate would be slight different from the actual real interest rate (which is calculated by above formula).

 Significance of Real interest Rate

Real interest rate is wide used in investment appraisal, because investors are more interest in real return than money return. It is important to note that risk may be analyzed more effectively with the help of real interest rate.

Limitation of real interest Rate

Real interest cannot be calculated exactly, because future inflation rate cannot be estimated exactly.

Characteristics of Real Interest Rate

1.    Real interest rate does not include inflation

2.    Real interest project real return for the investors.

3.    Real interest rate offered is based on assumed inflation rate in future.