Real Interest Rates

A real interest rate is the compensation, over and above inflation, that a lender demands to lend his money.

Since a lender is giving the use of his or her money to someone else, he or she is giving up or "forgoing" spending that money or "consuming". Obviously, the lender would not be interested in giving the use of his money to someone else for nothing in return. This compensation is called the "real interest rate". Economists have debated what this is and should be for many years. Until recently, most asserted that this rate was low and stable. They attributed the movement in interest rates to changes in inflation or its expected level. However, we now have evidence that "real interest rates" change substantially and in short periods of time. Inflation-linked bonds, which pay interest over inflation, have been available in the United Kingdom since 1981 and in Canada since 1991. These government bonds have seen their "real yield" move between 2.5% and 5.0%. This gives us some idea what an appropriate "real yield" should be. This rate increases when the demand for capital and borrowing is high in an economy, and falls when it is low.

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