Nominal vs. Real Interest Rates

Nominal Interest Rate

• The quoted or observable interest rate.
• The rate banks pay on deposits or charge on loans.
• Determines the number of dollars paid or received in interest.

Real Interest Rate

• The nominal interest rate adjusted for the effect of inflation.

• Reflects the increase in purchasing power.

  • Example: A nominal interest rate of 10% per annum with a 4% inflation rate results in an approximate 6% increase in purchasing power.

Relationship Between Real and Nominal Interest Rates

• R_n = Nominal interest rate

• R_r = Real interest rate

• \pi = Inflation rate

• Precise calculation:
  Rr = \frac{Rn - \pi}{1 + \pi}

• Approximation (accurate when inflation rate is low):
  Rr ≈ Rn - \pi