Why Real Interest Rates Are Positive

What this means

Your account balance grew by 3 percent this year. Are you better off? You cannot answer yet, because the question is missing a number.

The rate printed on the account is the nominal interest rateThe stated interest rate, before adjusting for inflation.. It tells you how many more dollars you have. What you actually care about is the real interest rateThe interest rate after adjusting for inflation, measuring the change in purchasing power rather than in dollars., which tells you how much more you can buy. The working approximation is the Fisher equationThe relationship stating that the real interest rate is approximately the nominal rate minus the inflation rate.: real rate is approximately the nominal rate minus the inflation rateThe rate at which the general price level is rising, so each dollar buys less than before..

So a 3 percent account in a year when prices rose 5 percent produces a real rate of about negative 2 percent. You have more dollars and less purchasing power. The bank statement looks like a gain; the grocery store reports a loss. The statement is not lying, it is simply denominated in the wrong unit.

Now the claim in the benchmark. Real interest rates are normally greater than zero, and the reason is a statement about human behavior rather than about banking. When you lend, you defer the use of real resources from the present into the future. You could consume today and instead you will consume later. People generally prefer the present, a tendency economists call time preferenceThe general preference for consuming now rather than later, which means future consumption must be worth more to be chosen., so they must be paid something to wait. That payment, in purchasing power terms, is the positive real rate.

There is a second reason from the borrower's side, and it reinforces the first. Borrowed resources are typically put to productive use: equipment, education, a building. If capital is productive, borrowers can afford to return more real resources than they received, and they will compete for funds by offering to do so. Time preference sets a floor on what lenders will accept; the productivity of capital establishes that borrowers can pay it.

Notice what is not in this argument. Default risk and inflation risk are real, and they raise the rate a lender demands, but the benchmark's claim would hold even for a perfectly safe loan with perfectly known inflation. Deferring consumption alone is enough to require compensation.

The word "normally" is doing honest work, though. Real rates can go negative, and have. A saver holding cash in a low-yield account during a burst of inflation earns a negative real return. Even safe government securities have at times carried negative real yields, when investors accept a small purchasing-power loss in exchange for safety and liquidity. These episodes are notable because they are exceptions to a strong tendency, not because the tendency is wrong.

Why it matters

This is the difference between saving and actually keeping your savings. If you are setting aside money for something years away, a college fund, a car, a first apartment, the relevant question is never how many dollars you will have. It is how much of that thing you will be able to buy.

Which is exactly why the account you choose matters. Many basic checking and savings accounts at large institutions pay very little. Money market accounts, high-yield savings accounts, certificates of deposit, and short-term government securities typically pay more. If one option pays a rate below inflation and another pays above it, the choice is not between a smaller gain and a larger gain. It is between losing purchasing power and keeping it. The trade-off you accept in exchange is usually reduced access to the money or a minimum balance requirement, and those are real costs worth weighing.

Try it

1. Write the Fisher approximation at the top of your page: real rate is approximately nominal rate minus inflation rate. Everything below depends on it.
2. Run four cases with a hypothetical 10,000 dollars held for one year. Case A: nominal 5 percent, inflation 2 percent. Case B: nominal 2 percent, inflation 5 percent. Case C: nominal 4 percent, inflation 4 percent. Case D: nominal 0 percent, inflation 3 percent. For each, compute the ending balance in dollars and the real rate.
3. Convert case B into goods to make it concrete. Choose something with a hypothetical price of 100 dollars at the start of the year. How many could you buy before? How many after prices rise 5 percent and your balance grows 2 percent? Write the answer as a count, not a percentage.
4. State the general rule your four cases produced, and identify exactly what condition makes a saver worse off in real terms.
5. Now the theory question. Explain in a paragraph why real rates are normally positive. Your explanation must center on deferring the use of resources from the present into the future, and must not rely on default risk or inflation risk, since the claim holds even without them.
6. Give the argument concrete form. Describe a lender you would need to persuade: someone with 10,000 dollars who could spend it today on something they want. Write what you would have to offer, stated in purchasing power rather than dollars, for them to agree to wait a year. Explain why offering exactly zero real return would fail.
7. Add the borrower's side. Explain how the productivity of borrowed capital makes it possible for a borrower to pay a positive real rate, using a specific example such as a machine, a truck, or job training.
8. Gather real data. Find today's inflation rate and the advertised rates on four different savings vehicles as described above. Build a table with columns for the product, its nominal rate, inflation, and the resulting real rate.
9. Rank your four options by real return and identify which ones lose purchasing power. Then name the non-rate cost of each higher-paying option, such as a withdrawal restriction, a minimum balance, or a term commitment.
10. Explore the exception. Explain how a real interest rate could be negative and why an investor might knowingly accept one, considering safety, liquidity, and the alternative of holding physical cash, which earns a nominal zero.
11. Write four sentences of advice to someone about to open their first savings account, explaining what number they should compare the advertised rate against and why the largest balance is not automatically the best outcome.

Check yourself