I was doing the introduction for

the John Bates Clark Medal at the American Economic Association.

And I was telling our own members at the AEA what did John Bates Clark

do that is most distinctive.

In 1895, he wrote a journal article defining what

he called the real interest rate.

What it is, is the interest rate corrected for inflation.

Now, I did a search to see if anyone knew of real interest rates before 1895.

And I got hits in 1894 and 1893, but nothing before that.

So I think it was John Bates Clark who invented the idea.

It's just amazing to me that people didn't understand forward rates,

they didn't understand real rates.

To me they seem like such natural concepts.

So the nominal interest rate,

what we've been talking about now, is quoted in currency.

Dollars, Pounds, Renminbi, whatever.

But it's not corrected for inflation, and

as you know when you have inflation, the value of the currency declines.

The real rate is quoted in terms of the market basket that

underlies the price index, consumer price index.

So just in simple terms, if you are investing money at 3% for

next year and the inflation rate, consumer price index,

is going up at 3% what is your real rate?

How much are you making in real terms?

Well, it's kind of obvious, it's zero, right?

If I have $3 more on my $100 investment, but

everything that I want to buy has gone up by 3% then I have the same buying power.

So I didn't get anything.

So the simple way of describing it is usually the real rate, this is simplified,

the real rate equals the nominal rate minus the rate of inflation.

But actually the formula is more like this.

One plus the nominal rate, or money rate,

equals one plus the real rate, times one plus the rate of inflation.

This is an approximation.

If you multiply this through, you'll see that it's missing the cross-product term,

the product of R money times I.

Which is close to zero.