A 5% interest rate sounds good. But what if prices rise 3%?
Ana saves €1,000 for a year
The bank pays 5%
After a year she has €1,050.
Prices rise 3%
What cost €1,000 now costs €1,030.
What she gained
She can buy only about 2% more than before.
The points to remember
- Real interest rate = nominal interest rate − inflation rate.
- The nominal rate is what the bank pays; the real rate is what your money gains in buying power.
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The real rate is the gap between two numbers, and it can be negative.
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Three made-up countries
| Country | Nominal rate | Inflation | Real rate |
|---|---|---|---|
| Corland | 5% | 3% | 5 − 3 = 2% |
| Tessaly | 4% | 7% | 4 − 7 = −3% |
| Halden | 1.5% | 1.5% | 1.5 − 1.5 = 0% |
Remember it as: Interest minus inflation. Below zero: savers lose.
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Who wins and who loses depends on the real rate.
A negative real rate
- Savers lose: their money buys less each year.
- Borrowers gain: they repay with money worth less.
- Borrowing and spending are encouraged: AD rises.
A high real rate
- Savers gain: their money grows faster than prices.
- Borrowers pay more in real terms.
- Borrowing and spending are held back: AD falls.
The points to remember
- Central banks watch the real rate: a negative real rate is expansionary even if the nominal rate looks high.
- Keep the sign: 15.4 − 19.9 = −4.5%, not 4.5%.
Paper 2 asked this in the specimen paper and again in November 2023, for 2 marks.
Table 1. Monetary data
| Item | 2015 |
|---|---|
| Central bank interest rate | 10.15% |
| Inflation rate | 9% |
Using information from Table 1, calculate the real central bank interest rate for 2015.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.
How the 2 marks are given
| You write | Marks |
|---|---|
| The working (for example 10.15 − 9) and the answer (1.15%) | 2 |
| Only the answer, or only the working | 1 |