Expected Real Interest Rate
There’s a lot on in “expected real interest rate,” so let’s do some dissecting to figure out what’s going on (gross, but necessary).
Whether you’re taking out a loan and you’ll be paying interest to your lender, or you’re opening a bank account and you’ll be collecting interest from your borrower, you’re dealing with interest.
Interest is the cost of borrowing.
If an interest rate is “real,” it takes inflation into account. What’s "not real" are the actual numbers we see, called the nominal interest rate. Nominal interest rates don’t take inflation into account, which is important since inflation changes the actual value, or buying-power, of money. So “real” in “real interest rate” means that you’ll be looking at the actual value of interest, regardless of time and inflation fluctuations.
"Expected" implies that we don’t really know what the interest rate will be, but we’ll do our best at guessing. If you’re opening a bank account that promises regular returns in interest, then you can calculate your expected real interest rate pretty easily. But...if you borrowed money and your interest rate is variable...the expected real interest rate (the money you owe to the bank) gets much more complicated to figure out.
Related or Semi-related Video
Finance: What is Compounding Value or Co...1773 Views
Finance allah shmoop What is calm Pounding value or compounding
interest Ah the power of compounding it makes tree's stronger
pollution More feral and the rich Well richer How so
Well let's start with compounds kissing cousin with six toes
Arithmetic calm pounding Right So the first was really geometric
compounding Now we're talking about arithmetic compounding If you invest
a thousand bucks in a ten year bond that pay
six percent a year in interest the dough comes back
to you in a pattern that looks like this Like
every six months they pay thirty bucks and it's sixty
dollars a year Got it nice You get the total
of sixteen hundred bucks back from your investment And the
cash that came back to you you know came in
small parts all along the way until you got about
two thirds of it or sixty percent at the end
right If you just spent that money and collected your
thousand bucks at the end That's it Okay So that's
arithmetic compounding the money comes to you You don't reinvest
it Ding ding ding that's the key here and you
just go buy burgers Okay So now let's look at
what six percent compound id looks like over the same
ten year period Wealth at the end of your one
it's a thousand sixty bucks and no we're only going
to compound it annually We probably should do the semi
annually but we confuse you even more is we won't
do that but then you essentially re invest that money
and you get another six percent compounded on that thousand
sixty instead of six percent compounded against the original thousand
so by the end of your two you'll have a
thousand one hundred twenty three sixty and by the end
of your ten you'll have one thousand seven hundred ninety
dollars and eighty five cents So why do you make
so much more money when you compound interest versus getting
thirty bucks twice a year like you would in this
bond example going by and burgers with it You don't
wanna do that well essentially what's happening is that you're
delaying your gratification of getting that sweet sweet cash or
getting liquid Whatever you wanna call it by reinvesting your
gains year after year after year So do you have
that sort of self control Do you need the cash
Yeah that's The question If you for example have trouble
making it home from your local pizza spot with the
pie intact well and compound interest Keeping the discipline to
not spend the money today and wait for the happiness
tomorrow Well when that may not be for you Sorry
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