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}
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\%
- This implies a decrease in purchasing power for the borrower.
Example Calculations
| Nominal Interest Rate | Inflation Rate | Real Interest Rate |
|---|---|---|
| 10% | 8% | 2% |
| 12% | 16% | -4% |
| 12% | 5% | 7% |
| 7% | 10% | -3% |
| 5% | -2% | 7% |
| 4% | 6% | -2% |
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.