What is the real rate of interest calculated as?

The real rate of interest represents the rate of return that has been adjusted for inflation, reflecting the true purchasing power of the interest earned. It is calculated by subtracting the inflation rate from the nominal rate of interest.

When inflation rises, the purchasing power of money decreases, meaning that the returns on investments need to account for this loss of value to accurately reflect a true profit. By subtracting the inflation rate from the nominal interest rate, you determine the rate that actually represents growth in value, as it considers how much the inflation erodes the returns.

For example, if you have a nominal interest rate of 5% and inflation is running at 2%, the real interest rate would be 5% - 2% = 3%. This indicates that although your nominal returns are 5%, the increase in prices means your actual purchasing power has only increased by 3%.

This method highlights the importance of considering inflation when evaluating investment returns, as it provides a more accurate measure of the financial gain related to the cost of living.