What is the Difference Between Nominal and Real Interest Rate?

The difference between nominal and real interest rates lies in the fact that nominal interest rates do not account for inflation, while real interest rates do. Here are the key differences between the two:

• Nominal Interest Rate: This is the interest rate advertised by banks, debt issuers, and investment firms for loans and various investments. It is the stated interest rate paid or earned by the lender or investor. Nominal interest rates can indicate current market and economic conditions.
• Real Interest Rate: This is the interest rate that factors in the effects of inflation on the purchasing power of the money being borrowed or invested. The real interest rate reflects the true cost of funds to the borrower and the real yield to the lender or investor.

The formula for calculating the real interest rate is the nominal interest rate minus the inflation rate. For example, if the nominal interest rate is 8% and the inflation rate is 3%, the real interest rate would be 8% - 3% = 5%.

Real interest rates can be negative when the rate of inflation is higher than the nominal interest rate. This means that the purchasing power of the money being borrowed or invested is decreasing over time due to inflation.

In summary, nominal interest rates provide a simple way of expressing the cost of a loan or the return on an investment, while real interest rates give a more accurate picture of the profit on a loan or deposit after taking into account the effects of inflation.

Comparative Table: Nominal vs Real Interest Rate

The difference between nominal and real interest rates lies in the fact that nominal interest rates account for inflation, while real interest rates do not. Here is a comparison table highlighting the differences between the two:

In summary, nominal interest rates are the stated interest rates that take inflation into account, while real interest rates represent the actual return on investments or loans, adjusted for inflation. To calculate the real interest rate, subtract the inflation rate from the nominal interest rate.