Definition
Nominal interest rate refers to the rate before taking inflation into account, and it is the rate that is quoted on documents and agreements. Real interest rate is the interest rate that has been adjusted to remove the effects of inflation. Essentially, the real interest rate is the nominal interest less the rate of inflation.
Key Takeaways
- Nominal interest rate refers to the simplistic, basic interest rate without any adjustment for inflation. It’s the stated or face value rate that does not take in consideration the economic factors that can affect the value of money over time.
- Real interest rate, on the other hand, provides an adjusted value that takes into account inflation rates. It tends to reflect the buying power of the revenue generated by the investment. Therefore, it is said to represent the ‘real’ earnings or cost of borrowing.
- ‘Nominal vs Real Interest Rate’ is an important concept as it helps investors understand the actual return on their investments or the true cost of borrowing. By considering the inflation rate, investors or borrowers can make more accurate and beneficial financial decisions.
Importance
Understanding the difference between nominal and real interest rates is crucial in finance because it provides a more accurate picture of financial return or cost.
Nominal interest rate refers to the interest rate without factoring in inflation, essentially the face value return or cost.
On the other hand, the real interest rate takes the impact of inflation into account, showing how much actual purchasing power is gained or lost.
If inflation is not considered, investors or borrowers could either overestimate their profits or underestimate their costs.
By comparing the real and nominal interest rates, individuals and businesses can make more informed financial decisions, effectively protecting their investments and managing their debts.
Explanation
The purpose of understanding the concept of Nominal and Real Interest Rates extends to manifold reasons and areas such as saving, loaning, or investing. A Nominal Interest Rate (NIR) typically gives the basic idea of how much interest one earns or pays, without taking inflation into account. Conversely, a Real Interest Rate (RIR) is adjusted for inflation, displaying how the buying power of certain interest-earned income has changed over time.
By providing a clearer lens of analysis, it helps investors comprehend more accurately about the total return on their investments amidst the ever-evolving economic climate. For instance, savers use these rates to decide the best place to store their money, while borrowers (including governments and corporations) use them to figure out optimal ways to finance their activities. Real interest rates play a pivotal role for investors as they assist in evaluating the actual return from their investments after accounting for the rate of inflation.
Without acknowledging real interest rates, they might be misled by nominal rates, which could cause them a decrease in purchasing power when inflation is high. Also, central banks monitor these rates to shape their monetary policy in order to curb inflation or stimulate growth. Therefore, both Nominal and Real Interest Rates are indispensable tools in the money and capital markets.
Examples of Nominal vs Real Interest Rate
Savings Account: A bank might offer a 3% nominal interest rate on savings accounts. However, if the inflation rate for that year is 2%, then the real interest rate earned on your savings is only 1%.
Home Mortgage: Let’s say you’ve taken out a home loan at a 6% nominal interest rate. If the inflation rate over the term of your loan averages 3% per year, the real interest rate you’re paying is actually 3%.
Government Bonds: Assume the U.S. government issues a bond with a nominal yield of 5%. If the rate of inflation is 2%, then the real return on that government bond is 3%. In all these examples, the nominal interest rate is what’s stated, but the real interest rate is what you effectively earn or pay once you factor in inflation. The real interest rate can be thought of as the purchasing power your money retains (or loses) after accounting for inflation. It’s also worth noting that if inflation is higher than the nominal interest rate, the real interest rate would be negative.
FAQ: Nominal vs Real Interest Rate
What is a Nominal Interest Rate?
The Nominal Interest Rate is the basic rate of interest that does not take inflation into account. It is the specified rate at which the principal will grow annually, excluding any compounding effects.
What is a Real Interest Rate?
The Real Interest Rate is the rate of interest after adjusting for the effects of inflation. It reflects the actual purchasing power of money generated by an investment, and the rate at which the value of the investment grows.
What is the difference between Nominal and Real Interest Rate?
The main difference between nominal and real interest rates is that nominal interest rates do not account for inflation, while real interest rates do. The nominal rate is typically higher as it does not consider economic factors such as inflation.
How are Nominal and Real Interest Rates calculated?
Nominal interest rate is usually given by banks or financial institutions. To calculate the real interest rate, you would subtract the inflation rate from the nominal interest rate. The formula used is: Real interest rate = Nominal interest rate – Inflation rate.
Why are Real Interest Rates important for economists and investors?
Real interest rates provide a more accurate measure of the actual return or cost associated with borrowing or lending money. It helps economists assess the true value of money over time, and helps investors in understanding the real gain or loss on an investment.
Related Entrepreneurship Terms
- Inflation Rate
- Purchasing Power
- Time Value of Money
- Real Rate of Return
- Fisher Effect
Sources for More Information
- Investopedia: A comprehensive website that provides detailed information on various finance-related topics, including Nominal vs Real Interest Rate.
- Council on Foreign Relations: A source for information that offers analyses on various global financial topics including Nominal vs Real Interest Rate.
- The Balance: This platform provides expert insights on all things finance and includes information about Nominal vs Real Interest Rate.
- Khan Academy: Offers a wide range of lessons on finance and economics, including lessons on Nominal vs Real Interest Rate.
