Which statement correctly describes the real interest rate?

• A. It is the nominal interest rate minus inflation
• B. It is the nominal interest rate adjusted for risk
• C. It equals the inflation rate
• D. It equals the nominal rate divided by inflation

Answer: (A)

Real interest rate shows how much your purchasing power grows after removing the effects of rising prices. It’s about the actual return in goods and services, not just money. The simplest way to get it is to subtract inflation from the nominal interest rate, which is why this description fits best. For example, if you earn 8% nominal and inflation runs 3%, the real rate is about 5% (roughly 8% − 3%; the exact calculation using (1+nominal)/(1+inflation)−1 gives about 4.85%). This distinguishes it from the inflation rate itself and from a rate adjusted for risk; dividing the nominal rate by inflation isn’t the correct method.