Nominal Versus Real Interest Rate
The real interest rate is the nominal rate of interest minus inflation. In the case of a loan, it is this real interest that the lender receives as income. If the lender is receiving 8 percent from a loan and inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are equal. A lender would have no net benefit from such a loan because inflation fully diminishes the value of the loan's profit.
The relationship between real and nominal interest rates can be described in the equation:
where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate.
- A common approximation for the real interest rate is:
- real interest rate = nominal interest rate - expected inflation
In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.
Read more about this topic: Nominal Interest Rate
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