In finance and economics, interest is considered the price of money, and it is subject to changes due to the supply and demand of available funds and inflation. The nominal interest rate, which refers to the price before adjustment to inflation and risk, is the one that is visible to the consumer. The nominal interest rate is composed of the real interest rate plus inflation plus any risk premium associated with the type of transaction.

The nominal interest rate is the percentage increase in money you pay the lender for the use of the money you borrowed on your credit card, auto loan or mortgage or the interest you may receive on your bank account, certificate of deposit or money market mutual fund. For instance, when a consumer deposits $100.00 in a bank and receives 8% interest on the deposit. At the end of one year, the depositor receives the $100.00 plus $8 in interest for a total of $108.00. This rate of return is the nominal rate of return and has priced into this rate some real rate of return, a minimal risk measure and a premium for inflation.

For the most part, the demand for goods and services is not related to the market interest rates quoted in the financial pages of newspapers, known as nominal rates. Instead, it is related to real interest rates, that is, nominal interest rates minus the expected rate of inflation. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation.

A simple formula for the nominal interest is:

i ( nominal interest rate ) = r ( real interest rate ) + π ( inflation premium ) + risk premium

The real interest rate = nominal interest rate – inflation ( expected or actual ) – any risk premium.

The real interest rate is the compensation to the investor for postponing consumption to a future time period. Ultimately, the real interest rate will be the growth rate of purchasing power resulting from an investment. Real interest rates are considered more meaningful than nominal interest rates because they take account of the adjustments in the purchasing power of money due to inflation. By adjusting the nominal interest rate to compensate for inflation, you are keeping the purchasing power of a given level of capital constant over time.

As an example, if a consumer is earning 5% interest per year on a savings account in a bank, and inflation is currently 2% per year, then the real interest rate they are receiving is 3%. The real value of your savings will increase by 3% per year, when the adjustment or changes in purchasing power are taken into consideration.

For example, a borrower is likely to feel a lot happier about a car loan at 8% when the inflation rate is close to 10% (as it was in the late 1970s) than when the inflation rate is close to 2% (as it was in the late 1990s). In the first case, the real (or inflation-adjusted) value of the money that the borrower would pay back would actually be lower than the real value of the money when it was borrowed. Borrowers, of course, would love this situation, while lenders would be disinclined to make any loans.

Inflation is a major factor determining the level of interest rates. The longer the term of the loan, the greater the risk that inflation can accelerate, reducing the purchasing power of the loan repayment. So, rates generally are higher on long-term loans than on short-term loans, because people who lend for longer periods have to be compensated for the risk that inflation might accelerate during the longer periods.

But the nominal interest rate doesn’t take inflation into account. In other words, it is unadjusted for inflation. Inflation is a rise in the general price level. A 5% inflation rate means that an average basket of goods you purchased this year is 5% more expensive when compared to last year. This leads to the concept of the real, or inflation-adjusted, interest rate. The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest. In our earlier example, the lender earned 8% or $8 on the $100 loan. However, because inflation was 5% over the same time period, the lender actually earned only 3% in real purchasing power or $3 on the $100 loan.

Policy also affects inflation directly through people’s expectations about future inflation. For example, suppose the Fed eases monetary policy. If consumers and businesspeople figure that will mean higher inflation in the future, they’ll ask for bigger increases in wages and prices. That in itself will raise inflation without big changes in employment and output.

No user commented in " Inflation, Nominal Interest Rates and Real Rates "

Follow-up comment rss or Leave a Trackback

Leave A Reply

 Username (*required)

 Email Address (*private)

 Website (*optional)