Inflation and Real Interest

1 + i = (1 + i^{'}) (1 + f) \Rightarrow i^{'} = \frac{i - f}{1 + f}

Market (combined) rate i includes inflation f. Real rate i' is the purchasing-power rate. Never mix then-current dollars with a real rate, or constant dollars with a market rate.

$i$: Market interest rate
$f$: Inflation rate
$i^{'}$: Real interest rate

Step-by-step solved example

Market i=10%, inflation f=4%. Real i'?

Market dollars vs real dollars on the same time axis.

1. Formula
i'=(0.10−0.04)/1.04=0.0577=5.77%.
$i^{'} = 5.77%$
2. Check
(1.0577)(1.04)≈1.10.

Answer: i' = 5.77%

10 practice questions

0/10 correct

1.If f=0 then i' equals

2.Then-current (actual) dollars pair with

3.Constant-dollar analysis uses

4.i=8%, f=8% → i' =

5.If f>i the real rate is

6.A price escalating at e, discounted at i, uses

7.Approximate i'≈i−f is

8.i=12.36%, f=6% → i' nearest

9.Mixing inflated A with real i' will

10.f is measured on