The real interest rate reflects the impact of inflation on stated interest rates in the economy. The real interest rate helps investors gauge the actual cost and value of investment borrowing, which may cause an increase or decrease in the level of investment.
The interest rate measures the demand for money by investors. Generally, during strong economic growth, the demand for investment borrowing increases. Conversely, during weak economic conditions investment activity may decrease.
Depending on economic conditions, investors may have positive or negative expectations of future economic growth. If the expectation is positive, the investment level may increase and encourage inflation with the increased demand for borrowing.
The real interest rate is calculated by subtracting the inflation rate from the interest rate. This calculation may help lenders hedge against the effects of inflation and lend money at higher interest rates.
When inflation devalues a stated interest rate, the resulting low real interest rate encourages an increase in the investment level.
The real rate may not always lower the value of stated interest rates. If inflation does not affect the real interest rate, the investment level may remain unchanged.