Nominal Interest Rate
Definition
Nominal Interest Rate
The market interest rate before inflation is taken into account.
Real Interest Rate
Definition
Real Interest Rate
The interest rate which has been adjusted for inflation.
- It reflects the true cost of borrowing or the real return on savings.
Calculation of Real Interest Rate
- The real interest rate can be calculated using the following formula:
- $\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Rate of Inflation}$
The real interest rate can be negative if the inflation rate is higher than the nominal interest rate.
Example- Imagine that the annual rate of inflation is 5%, and the nominal interest rate is at 8%.
- Therefore the real interest rate will be:
$$8-5=3\%$$
- If you have 100\$ in the bank, before inflation you would have earned 8\$, but in reality you earned 3\$, due to inflation.
Importance of Real Interest Rates
The real interest rate is important because it reflects the true cost of borrowing and the real return on savings.
- It helps borrowers and savers make informed decisions about loans and investments.
- It is used by policymakers to evaluate the effectiveness of monetary policy.
