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Thursday, March 16, 2006

Calculating and Understanding Real Interest Rates

In my introductory finance class, we just covered the concept of "real" and "nominal" interest rates. The "nominal" rate is the rate you actually observe (i.e. you earned 6% on your money this year). The "real" rate is the inflation-adjusted rate - the amount of purchasing power you gained. Roughly speaking, if inflation was 4% and you earned 6% on your money, a year down the road you would be able to buy approximately 2% more in goods than you can today. IN other words, the real rate in this example would be approximately 2%.

For a good explanation of the topic (and an example of how to calculate real rates), read the following piece put together by Mike Moffatt at About Economics titled Calculating and Understanding Real Interest Rates.

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