Suppose we have an inflation in a country with an annual 2% and we get a loan for an annual 1% (real interest). Is the money we receive free? This is a common practice in some European countries, where the mortgages are around 1% fix rate plus the Euro Interank Offered Rate. If so, why? Are the banks loosing money by lending in such low rates?
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1$\begingroup$ Is the interest of $1\%$ real or nominal? $\endgroup$– RegioMay 8 '19 at 21:36
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$\begingroup$ Please accept the answer if it was helpful $\endgroup$– StudentMay 9 '19 at 17:23
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$\begingroup$ To be clear, we are talking about an interest rate = EURIBOR + 1%? $\endgroup$– dismalscienceMay 10 '19 at 1:21
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"Real interest" means the interest after subtracting inflation. Interest including inflation would be called "nominal interest".
If inflation is 2%, then 1% real interest means 3% nominal interest, which is the interest that is written in the loan contract and is what you actually have to pay. You would have to pay \$300 interest on a \$10000 loan. However, if you put the \$10000 into a savings account that matched inflation, you would have \$10200 at the end of it. So you would have lost \$100 overall.
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Inflation: 2% Interest: 1%
This means the real rate is 3%. So no; not free money.
Free money would be negative interest rates. Example: Inflation: 0%. Interest on loan I get from the bank: -1%. This would mean they are paying ME 1% to take the loan from the bank.
Negative interest rates are a real practice, with many historical examples that can be researched.
The banks are theoretically losing 1%(+2% inflation) on the loaned amount, however it's important to understand that deals are made among negotiations with central banks in the background that can still produce gains from this.
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$\begingroup$ You are taking his question in the wrong way. Please see my answer below. $\endgroup$– StudentMay 9 '19 at 17:16
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$\begingroup$ You repeated my answer but said it differently. $\endgroup$ May 9 '19 at 17:43
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1$\begingroup$ If inflation is 2% and nominal interest is 1%, then the real interest rate is -1%. $\endgroup$ Jun 10 '19 at 0:29
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$\begingroup$ Sorry but that is not correct, you do not subtract them, you add them for the real interest rate. If I take a loan out from the bank at a nominal interest rate of 1%, and inflation is 2%, then I'm effectively paying 3%. The bank's return on the loan however is -1%. $\endgroup$ Jun 10 '19 at 18:06
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You have the right intuition.
However, 1% is usually the real interest rate.
Real interest rate = nominal interest rate - inflation
So, you are actually, usually, paying a 3% annual rate.
If that is not the case, your question does not specify if 1% is nominal or real, then just having inflation of x% does not mean that you are increasing your wealth my that much each year.
Example: Inflation is 10%. The best investment opportunity provides a return of 0.5%. By the end of the year, I am still losing 9.5% of my wealth. But does that mean that I should not invest at all? If I don't then I will lose 10% which is wrose.
I hope that helps.
