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

  • RnR_n = Nominal interest rate

  • RrR_r = Real interest rate

  • π\pi = Inflation rate

  • Precise calculation:
    R<em>r=R</em>n−π1+πR<em>r = \frac{R</em>n - \pi}{1 + \pi}

  • Approximation (accurate when inflation rate is low):
    R<em>r≈R</em>n−πR<em>r ≈ R</em>n - \pi