The real interest rateinterest rates and inflationsuppose, Ask an Expert

Economics

The real interest rate

Interest rates and inflation

Suppose you have 1 million on 1st January 2008. A basket of goods and services similar to the CPI basket costs 100,000. You can then buy exactly 10 such baskets on 1st January 2008.

Say that you can invest your million at a 10% interest rate. On 1st January 2009 you will then have 1.1 million. 1.1 million may not be enough for 11 baskets as prices may have changed. Say that inflation was 4% in 2008. The price of a basket has then increased to 100,000 * 1.04 = 104,000 and you can buy 1,100 / 104 = 10.58 baskets, which is 5.8% more than last year. Even though your wealth has increased by 10% (in whatever currency you use), your real wealth (in baskets) has only increased by 5.8% and we say that the real interest rate is 5.8%.

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Macroeconomics, Economics

Category:- Macroeconomics
Reference No.:- M9582434

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