| Real Interest Rate |
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| inflation | |
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| SHOPPER'S DELIGHT | |
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For example, if somebody lends $1000 for a year at 10 percent, and receives $1100 back at the end of the year, this represents a 10 percent increase in his wealth if prices for the average goods and services that he buys are unchanged from what they were at the beginning of the year. However, if the prices of the food, clothing, housing, and other things that he wishes to purchase have increased 20 percent over this period, he has in fact suffered a real loss of about 10 percent in his wealth. This simple definition is much more complicated in practice. For example, if the recipient of the interest has to pay income tax, it is usually levied on the nominal interest rate, and so the tax rate will also affect the real interest rate. Except for loans of a very short duration, the inflation rate will not be known in advance. People often base their expectation of future inflation on an average of inflation rates in the past, but this gives rise to errors. The real interest rate after the fact may turn out to be quite different than the real interest rate that was expected in advance. This had very harmful effects on the wellbeing of lenders during the 1960s and 1970s when inflation was on a rising trend. Conversely, in the 1990s, when inflation was on a downward trend in most countries, lenders fared well, while borrowers ended up paying much higher real borrowing costs than they had expected. The complexity increases for bonds issued for a long term, where the average inflation rate over the term of the loan may be subject to a great deal of uncertainty. In response to this, many governments have issued real return (also known as inflation indexed bonds), in which the principle value rises each year with the rate of inflation, with the result that the interest rate on the bond is a real interest rate. The expected or equilibrium real interest rate can vary considerably from year to year. The real interest rate on short term loans is strongly influenced by the monetary policy of central banks. The real interest rate on longer term bonds tends to be more market driven, and in recent decades, with globalized financial markets, the real interest rates in the industrialized countries have become increasingly correlated. Real interest rates have been low by historical standards since 2000, due to a combination of factors, including relatively weak demand for loans by corporations, plus strong savings in newly industrializing countries in Asia. The latter has offset the large borrowing demands by the US Federal Government, which might otherwise have put more upward pressure on real interest rates. SEE ALSO EXTERNAL LINKS
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