Importance in Economic Theory
Economics relies on measurable variables, chiefly price and objectively measurable production. Since production is "real", while prices are relative to the general price level, in order to compare an economy at two points in time, nominal price variables must be converted into "real" variables. For example, the number of people on payrolls represents a "real" variable, as does the number of hours worked. But in order to measure productivity, the nominal prices of the goods and services that labor produces must be converted to the "real" purchasing power. To do this requires adjusting prices for inflation.
The same is true of investment. Investment produces real gains in efficiency, and purchases productive capacity - factories, machines and so on - which is also real. To find the return on this capital, it is necessary to subtract the increases in its nominal value that are the result of increases in the general level of prices. To do this means subtracting the inflation rate from the nominal rate of return. For example, a portfolio of stocks that returns 10%, when inflation is running at 4% has a 6% real rate of return.
The real interest rate is used in various economic theories to explain such phenomena as the capital flight, business cycle and economic bubbles. When the real rate of interest is high, that is, demand for credit is high, then money will, all other things being equal, move from consumption to savings. Conversely, when the real rate of interest is low, demand will move from savings to investment and consumption. Different economic theories, beginning with the work of Knut Wicksell have had different explanations of the effect of rising and falling real interest rates. Thus, international capital moves to markets that offer higher real rates of interest from markets that offer low or negative real rates of interest triggering speculation in equities, estates and exchange rates. Related to this concept is the idea of a "natural rate of interest", that is, the expected return on savings and capital invested.
Read more about this topic: Real Interest Rate
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