Final answer:
The real interest rate is found by subtracting the inflation premium from the nominal interest rate. If the nominal rate is 8% and the inflation premium is 5%, the real interest rate is 3%. This rate reflects the true gain in purchasing power from an investment, after accounting for inflation.
Step-by-step explanation:
To calculate the real interest rate, we subtract the inflation premium from the nominal interest rate. Suppose that the inflation premium is 5 percent and the nominal interest rate is 8 percent, we can find the real interest rate by doing the following calculation: 8% - 5% = 3%. Therefore, the real interest rate is 3%. This is the rate that indicates the true increase in purchasing power that an investment offers after accounting for inflation.
This concept is important in finance because the nominal interest rate does not accurately reflect the increase in purchasing power provided by an investment due to inflation. For example, if you invest money at a nominal interest rate of 8% but the inflation rate is 5%, you are not really getting an 8% increase in buying power—your real increase in buying power is only 3%.
Additionally, the effects of inflation and real interest rates have significant implications on the economy, as they influence the decisions of borrowers and lenders, and can impact overall economic stability.