Calculating Real Interest Rates Using Change in Value
Bearing in mind that a real interest rate is simply the proportion of return or proportion of loss of a changed revenue stream after inflation has been factored in, we could use a simple change formula to calculate the real rate of change in income based on the new living costs.
Using the example above, for negative real rates of interest, where the standard bank loan rate is at 2% and the rate of inflation is 10%, we can use the following formula.
RIR =
Where:
- RIR= Real Interest Rate
- NIR= Nominal Interest Rate effect on initial investment
- I= Inflationary effect on initial investment
So let’s assume a consumer borrows £200,000 from this bank.
Calculating the nominal change on initial value or "NIR" is simply £200,000 + 2% = £204,000
The inflationary effect on the initial value or "I" is calculated as £200,000 + 10%= £220,000. We calculate this value because we want to find the amount of money which is required to buy the same volume of goods and services in the following time period as £200,000 did in the preceding period.
So NIR - I = £204,000 - £220,000 = - £16,000.
This difference is the top line of the equation and shows that the ‘real’ debt is negative since the price of the debt rose at a lower rate than the money supply rate. So in effect, the creditor is losing £16,000 at prices in the latest time period. This is because the £204,000 return doesn’t reflect the same purchasing power in the current time period as £200,000 did in the preceding one. Assuming the borrowers annual income is £200,000, if this rose in line with inflation, he/she would gain £16,000 in latest money terms. If this income grew at 2%, he would find his loan no less easy or harder to pay but would find other items which grew at a higher rate of inflation more expensive.
This change represents the inflationary adjusted change in value and so by dividing it by this by the inflationary effect on the initial value and then multiplying by 100, we can get the percentage change on value based on the inflated value.
Therefore: RIR = (-£16,000/£220,000) X 100 = -0.07272 X 100 = -7.27%
This means that assuming a person’s valued income or wealth rose by the same level of inflation, the loan is around 7.3% lower in real value and would therefore represent a transfer of wealth from the bank to the repaying individual. Obviously, this would lead to commodity speculation and business cycles, as the borrower can profit from a negative real interest rate.
Read more about this topic: Real Interest Rate
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