Nominal Interest Rate vs Real Interest Rate

Nominal Interest Rates vs. Real Interest Rates

Interest rates are a fundamental part of financial economics. They help us evaluate and compare different investments or loans over time. However, if we compare financial data over time, we have to consider the effects of inflation. This is why we distinguish between two different types of interest rates in economics: the nominal interest rate and the real interest rate. We will look at both of them in more detail below.

Nominal Interest Rate

The nominal interest rate describes the interest rate without any correction for the effects of inflation. Thus, the advertised or stated interest rates we see on bonds, loans or bank accounts is usually a nominal one. This rate shows you the actual price you are paid (or have to pay) if you lend (or borrow) money. Simply put, it shows you by how much the amount of money you have in your bank account increases over time.

To give an example, let’s assume you deposit USD 10’000 in your bank account. The account pays an annual interest rate of 3%. After one year your balance has increased to USD 10’300. That means, you have accumulated USD 300 in interest on your account. The annual interest rate of 3% in this example is the nominal interest rate. However, if you are familiar with the concept of inflation, you will know that this does not necessarily mean that you are in fact USD 300 “richer” now. As implied above, to see how much you can actually profit from a 3% nominal interest rate, we need to consider the effects of inflation. And that’s where the real interest rate comes into play.

Real Interest Rate

The real interest rate refers to the interest rate adjusted to remove the effects of inflation. This rate shows you by how much the actual purchasing power of the money you have in your bank account increases over time. In other words, it describes the real yield of lending money or the real cost of borrowing money (hence the name). Calculating the real interest rate is actually quite simple. All we need to do is take the nominal interest rate and subtract the inflation rate. This equation is also referred to as the Fisher equation.

How to calculate real interest rate

To illustrate this, let’s revisit our example. In one year, you accumulated USD 300 in interest with a nominal interest rate of 3%. Now, let’s say during the same period, the overall price level in the economy has increased by 1%. In this case, your money is worth less now than it was a year ago. Its buying power has decreased, because now you need more money to buy the same amount of goods. Therefore, to see how much you can actually profit from the additional USD 300, we need to adjust for the effects of inflation. In our example, that means we subtract 1% (inflation rate) from 3% (nominal interest rate), which results in a real interest rate of 2%. That means, your actual buying power has increased by 2%.

In a Nutshell

Interest rates help us evaluate and compare different investments or loans over time. In economics, we distinguish between two types of interest rates: the nominal interest rate and the real interest rate. On one hand, the nominal interest rate describes the interest rate without any correction for the effects of inflation. On the other hand, the real interest rate refers to the interest rate adjusted to remove the effects of inflation.

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