Financial Sector - Nominal vs Real Interest Rates

Financial Sector

• Unit 4: Financial Sector

  • Focus on the relationship between interest rates and inflation.

Topic 4.2: Nominal vs. Real Interest Rates

• Definitions:

  • Nominal Interest Rates: Current interest rates without adjustment for inflation.

  • Reflects the percentage increase in money that a borrower pays.

  • Real Interest Rates: Adjusted for inflation, reflecting the actual increase in purchasing power that a borrower pays.

  • Formula: $Real = Nominal - Expected \text{Inflation}$$$Real = Nominal - Expected \text{Inflation}$$

Key Concepts

• Difference:

  • Nominal = Real + Expected Inflation

  • Real = Nominal - Expected Inflation

• Significance of Interest Rates:

  • Lenders charge interest rates to compensate for the time value of money and risk.

  • Example: If a borrower plans to pay back a $100 loan in 2050 with a total interest rate of 100%, the nominal interest rate is 10% and expected inflation is 15%.

• Calculating Real Interest Rate:

  • If nominal interest rate is 10% and inflation rate is 15%, the real interest rate would be:

  • $Real = 10\% - 15\% = -5\%$$$Real = 10\% - 15\% = -5\%$$

  • This implies a decrease in purchasing power for the borrower.

Example Calculations

Historical Context

• 2008 Financial Crisis:

  • Understand the role of interest rates in financial crises, bailout practices, and the concept of perverse incentives in lending.

• Engagement

  • Reflect on economics of interest rates and how they affect individual and systemic financial situations.