Interest, Real Rate of
Interest, Real Rate of
The real rate of interest is the money rate adjusted for the loss, due to inflation, of the purchasing power of the amount lent. In short, the real rate of interest is equal to the money rate of interest less the rate of inflation. This statement is often called the Fisher equation after Irving Fisher (1867–1947), an American economist who developed it in a series of publications in the first thirty years of the twentieth century. Looking back at interest rates and inflation at the end of a period, it is possible to use statistics to calculate how the real rate of interest behaved over that period. However, what is of major interest in economics is what decision makers think real interest is going to be in the future period relevant to the decision being made. Thus, in economics, as opposed to economic history, the size of the real rate of interest is something people think will hold in the future. It cannot be measured precisely. However, if at the end of a period the Fisher equation has not held, either the inflation rate was not what was expected at the beginning of the period or people did not fully take inflation into account and suffered, at least to some extent, from what is called money illusion. This latter view was the one held by Fisher himself. In his 1930 book The Theory of Interest, he argued that the relationship between the real rate of interest, the money rate, and inflation was a long-run relationship that only held when the rate of inflation did not change much over a long period. He thought that when the rate of inflation fluctuated, the rate of interest adjusted to some extent but not by enough to compensate fully, or even largely, for the changes in the rate of inflation; Fisher squarely blamed money illusion for this.
Although the real rate of interest is normally defined by the Fisher equation, it has a large role to play in economic theory apart from any relationship between inflation and interest rates. The dominant school in economics holds that the real rate of interest is the price that brings into equality the demand and supply of savings. The demand for savings comes partly from those who want to obtain income in the future either by investing in physical capital goods or by increasing their ability and skills. Demand also comes from those who wish to consume more now, relative to their income in the future. The supply of savings comes from those who wish to consume more in the future, relative to income, than now, those who are saving to buy a capital good in the future, and those who have borrowed in the past and are paying off loans. Overall, these various components of demand and supply depend on things that only change slowly, such as demographics, the rate of productivity change, institutions, and culture. When the underlying demand for savings equals the underlying supply of savings and there is no tendency for the rate of inflation to change, the real rate of interest is called the equilibrium real rate of interest. It is this rate that economists often have in mind when they are discussing real interest rates. It sums up for the community overall the degree to which future benefits and costs are discounted compared to those in the present. Depending on the context, this is called the rate of time preference or the social discount rate.
Modern economic theory assumes that money illusion is unimportant, that the economy moves quickly to a position of equilibrium, and that in equilibrium the real interest rate is stable. Taken together, these three propositions suggest that the real interest rate is less volatile than the money interest rate. However, empirical studies suggest that this is not the case and that, when the rate of inflation varies, the money interest rate adjusts less than it should if the above three propositions are correct. Given that it is the expected rate of inflation when decisions are made that is relevant, the key issue in these studies is how to measure expected inflation. Some studies use survey data. Others assume a variety of mechanisms by which peoples’ expectations are formed and use statistical techniques to measure the expectations, determined from the past data that formed expectations. Generally these studies show that, assuming a relatively stable real interest rate, the Fisher equation does not hold. Various ingenious propositions have been put forward to explain this, but the weight of the evidence confirms Fisher’s view that money illusion has a significant role to play in the operation of the economy.
The real rate of interest is an important concept in economic theory. However, because this theory largely ignores money illusion, its relevance to economic policy is greatly reduced.
SEE ALSO Expectations; Fisher, Irving; Inflation; Interest, Natural Rate of; Interest Rates; Interest Rates, Nominal; Investment; Money; Money Illusion; Policy, Monetary
Fisher, Irving. 1930. The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity to Invest (Pts. I and II). London: Macmillan.
Summers, Lawrence H. 1983. The Nonadjustment of Nominal Interest Rates: A Study of the Fisher Effect. In Macroeconomics, Prices, and Quantities: Essays in Memory of Arthur M. Okun, ed. James Tobin, 201–240. Washington, DC: Brookings Institution.
J. W. Nevile