In order to understand the meaning of real interest, it is best to understand first the meaning of the terms inflation, price index, and Consumer Price Index.
Inflation is synonymous with a consistent rise in prices.
During a period when prices are rising, the purchasing power of money is eroded, as shown by the following:
On date A (the beginning of the period), we were able to buy 100 anemones for $100 ($1 per flower).
On date B (the end of the period), we will not necessarily still be able to buy 100 flowers for $100.
If the price of flowers increases by 30% between date A and date B, the price of a single flower will rise to $1.30, and we will be able to buy only 77 flowers. This means that the purchasing power of our $100 has been eroded (depreciated).
The purchasing power of money is always eroded during a period of rising prices (inflation). Inflation behaves as though it is a tax levied on those who hold USD.
An index is a method or technique used to monitor the development of prices of a product
(or a basket of products).
For monitoring purposes, we periodically examine the price of the product and every such examination is called an “observation”.
For purposes of the index, the price obtained from the first observation represents 100 points (or 100%), and the prices of the following observations become larger or smaller than 100 (depending upon the rise or fall in the price obtained during those observations), and as compared with the price obtained from the first observation.
For example, if we examine the price of bread once per month, and five months after the first observation the price of bread has risen by 5%, the index will be at 105 points.
If the price rises by 30%, the index will be at 130 points.
If the price falls by 5%, the index will be at 95 points.
Another explanation and additional examples are presented in the next section.