Real interest parity: the concept of the real inte...
The real interest parity (RIP)hypothesis postulates that, if the world markets for goods, capital and foreign exchange are integrated, real interest rates on perfectly comparable financial assets tend to be equalized across countries over time.Obviously, this has implications for investment and financing decisions in the sense that, if the hypothesis held precisely, currency denomination of investment and financing portfolio would not matter.
We start by defining the real interest rate.Suppose that an investor is contemplating buying a financial asset such as a Treasury bill or a certificate of deposit.The investor knows in advance that on the maturity of the investment, he or she will receive the principal and some return measured by the nominal interest rate, which is the quoted, inflation-unadjusted interest rate.Thus, if the principal, K, is invested at time 0, and assuming that the investment matures at time 1 and that the underlying (nominal)interest rate is i, then on maturity the investor receives K(1+i).The real value of this amount, however, depends on the general price level prevailing at time 1.What is meant by the real value is the quantity of goods and services that can be obtained in exchange for this nominal amount.
Let us assume that at time 0, when the investment is undertaken, the general price level is P0.The real value of the capital invested is obtained by deflating (that is, dividing)the amount by the prevailing price level.This means that the real value of K at time 0 is K/P0.At time 1, the real value of the amount K(1+i)is K(1+i)/P1.Now, remember that the nominal interest rate is calculated from the nominal amounts [K and K(1+i)], whereas the real interest rate is calculated from the real amounts [K/P0 and K(1+i)/P1].Let the real interest rate be r, then
This equation can be manipulated to produce
Since P1/P=1+P˙, where P˙ is the rate of change of the price level between 0 and 1 (that is, the inflation rate), it follows that
which gives
If we ignore rP˙ because it is small, Equation (5.38)reduces to
This tells us that the real interest rate is the nominal interest rate minus the inflation rate over the holding period.If the inflation rate is higher than the nominal interest rate, the real interest rate is negative.This is the case when the amount consisting of the principal and interest received at time 1 buys a smaller quantity of goods and services than could be bought with the principal only at time 0.
The real interest rate defined by Equation (5.39)can only be determined at time 1 when the inflation rate over the holding period is known.This rate tells us how well the investor has done after the fact and so it is described as an ex post real interest rate.What is important for investment and financing decisions is the real interest rate that is expected at time 0 to prevail over the holding period between 0 and 1, which is the expected or ex ante real interest rate.An investor who wants to buy a financial asset at time 0 will contemplate the real interest rate to be obtained on the investment.Obviously, if the expected real interest rate is negative, then the investor may consider another investment, perhaps real estate, if the latter gives a positive expected return.The real interest rate cannot be known at time 0 because the inflation rate is not known then.Thus, the expected or ex ante interest rate is obtained by subtracting the expected inflation rate from the nominal interest rate, which gives
This relationship is also known as the Fisher equation or the Fisher hypothesis after its founder, US economist Irving Fisher.