Principles of Macroeconomics / Unit 6 MAC 0515 worked example, 60 to 90 seconds
Computing the Real Interest Rate
The idea
Subtract the inflation rate from the nominal rate. The answer can be negative, and often is when inflation runs above the rates on deposits. Then ask who the outcome favors. A borrower with a fixed nominal rate gains when inflation turns out higher than expected, because the payments are fixed and the money they are made in is worth less. The lender loses by exactly the same amount. If inflation turns out lower than expected, the two reverse.
In practice
Worked example: a fixed loan at six percent with inflation expected at two. The expected real rate is four percent. Inflation instead comes in at seven, so the realized real rate is minus one. The borrower repays in money worth less than either party expected and gains; the lender receives it and loses. Neither did anything differently.
Where people slip
What matters is whether inflation was anticipated, not whether it was high. Inflation both sides expected is already in the nominal rate, so it redistributes nothing. Only the surprise moves purchasing power between them.
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