Real Rate of Interest

Study guide: Exam FM-2

The real rate of interest i_r adjusts the nominal Interest Rate i for the effect of Inflation r, representing the true growth in purchasing power:

1 + i_r = \frac{1+i}{1+r}

i_r \approx i - r \text{ (for small rates)}

• If the nominal rate exceeds inflation, the real rate is positive (purchasing power grows).
• If inflation exceeds the nominal rate, the real rate is negative.
• The real rate is essential for comparing investment returns across different inflationary environments.

Inflation-Adjusted Return A bond pays a nominal yield of 8%. Inflation is running at 3%. Find the real rate of interest.

Answer i_r = \frac{1.08}{1.03} - 1 = 1.04854 - 1 = 4.854\% The investor's purchasing power grows at approximately 4.85% per year.