Nominal and Real Interest Rates

Nominal and Real Interest Rates

Nominal Interest Rate

The nominal interest rate is the interest rate before adjusting for inflation. It represents the percentage increase in money that a borrower pays to a lender over a specific period.

• Key Points:
  • It is the stated or advertised rate by financial institutions.
  • Does not account for changes in purchasing power due to inflation.
  • Commonly used in loan agreements, savings accounts, and investment returns.

Example: If a bank offers a nominal interest rate of 5% on a savings account, the amount in the account will grow by 5% annually in monetary terms.

Real Interest Rate

The real interest rate is the interest rate adjusted for inflation. It gives a more accurate picture of the true cost of borrowing or the real yield on investments by accounting for inflation.

• Key Points:
  • Measures the increase in purchasing power, not just money.
• • Calculated using the formula:
• Real Interest Rate=Nominal Interest Rate−Inflation Rate
  • Reflects the actual benefit of saving or investing and the true cost of borrowing.

Example: If the nominal interest rate is 5% and the inflation rate is 3%, the real interest rate would be 2%, meaning the actual purchasing power only increased by 2%.

Key Takeaways:

Summary

• The nominal interest rate reflects the rate in monetary terms.
• The real interest rate reflects the rate in terms of purchasing power after accounting for inflation.