Question

(i) Explain the concept of a 'Real Rate of Interest. How does the real rate of interest differ from the notional interest rate charged against (or received) by consumers of financial products? Explain the 'real rate of interest' principle using the example of a client who has $100,000 of their money invested in an 'at call, bank account which is currently paying 0.5% per annum. (8 marks)

Answer 1

Real rate of interest: Real rate of interest is the rate of interest adjusted by the inflation.

We know that the purchasing power of money decreases with the increase in inflation. For example suppose today the price of 1 kg mango is $1 but after one year the inflation shall increase by 10% means the price of 1kg mango will become $1.1.

So if we are going to receive interest of 20% one year from now at $10 invested today the real value of interest receivable shall not be $2 while it shall be only $.9091. (after 1year sell investment for $10 and get interest of $2 total $12 and buy mangoes with $12 i.e.12/1.1=10.9091kg mangoes means only .9091kg more that that could have been purchased one year ago in percentage terms .9091/10*100=9.091%) Hence real rate of interest shall be 9.091%. We can calculate

Hence real value of interest is find by interest/(1+inflation) e.g. 1.1/1+.1=1.

Hence formula of real rate of interest shall be= (1+interest rate) / (1+inflation rate) - 1

In our example =1.2/1.1-1=.09091 or 9.09091%
How real rate of return differ from nominal rate?

Real rate of interest is the interest rate adjusted for inflation while the nominal rate of interest is the rate not adjusted for inflation.

Calculating real rate of interest : If a clint has invested $100000 in a bank @.5% per annum and suppose inflatin rate is .2%.

Invest today $100000

earn interest after one year 500

sold investment $100000

Total received =100500

Purchasing power of $100500=100500/1.002

=100299.4

Real return from investment=299.4(i.e.100299.4-100000)

Percentage of return=299.4/100000*100

=.2994%

We can calculate real rate of interest with the help of above mentioned formula:

Real rate of interest=1+.005/1+.002 - 1

=.002994 or.2994%

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