Definition of Real Interest Rate
Real interest rate is the interest rate that is prevailing in the market without the effect of inflation in it. It is the rate that is used to discount real cash flows in investment appraisal. There is a formula from which we can calculate the real interest rate from the nominal interest rate.
Formula for Real Interest Rate:
(1+ Nominal Interest rate) = (1+ Real Interest rate) x (1+ Inflation rate)
Example of Real Interest Rate:
Let’s assume that the inflation rate in the economy is 5%, and the nominal interest rate is 13%, then the real interest rate will be as follows.
(1+13%) = (1+ Real Interest rate) x (1+5%)
Real Interest rate = (1.13/1.05) – 1 = 0.0762 or 7.62%