Question

You invest $100 in an interest-bearing bank account for 1 year. Suppose that the price of apples today is $2 per unit. If the nominal interest in the bank account is 2% and the price of apples a year from now is $2.5, what is the real interest rate from your one-year investment? Explain with words what a real interest rate is.

Answer 1

We know that the nominal interest rate = inflation rate + real interest rate

From the above information we know that the price of apple in period t = $2

The price of apple in period t+1 = $2.5

Therefore, we can calculate the rate of inflation as

(2.5-2)/2 = 0.5/2 = 0.25

Therefore the rate of inflation for the next period = 0.25

Going back to the equation -

Nominal Interest rate = Inflation rate + Real Interest rate

0.02 = 0.25 + Real interest rate

Real interest rate = -0.23 or -23%

Real interest rate is the rate at which the investor or lender receives interest after taking inflation into consideration. The real interest rate is therefore the difference between the nominal interest rate and the inflation rate. The real interest rates can also be negative if inflation exceeds the nominal rate of interest.