Difference Between Nominal and Real Interest Rate
The difference between nominal and real interest rate can be understood with the help of the Fisher equation. The Fisher effect states that the nominal interest rate is simply the sum of the real interest rate and expected inflation.
The idea behind the Fisher effect is that real rates are relatively stable and changes in interest rates are driven by changes in expected inflation. This is consistent with money neutrality.
Investors are exposed to the risk that inflation and other future outcomes may be different than expected. Investors require an additional return (a risk premium) for bearing this risk, which we can consider the third component of a nominal interest rate.
Essentially the difference between these rates is inflation. It is important to understand these rates because nominal rates do not show the entire story for investment returns or the economy.
Nominal Interest Rate vs Real Interest Rate Infographics
Let’s see the top differences between nominal vs real interest rate.
Key Differences Between Nominal and Real Interest Rate
- The nominal interest rate is the simplest interest rate to understand. It does not consider any other factors. On the other hand, the real interest rate takes into account the effect of inflation on the rate and gives a clear picture.
- Nominal Interest Rate can be calculated as = Real interest rate + Inflation rate
- Real interest rate = Nominal interest Rate – Inflation
- If the inflation is increasing and exceeds the nominal interest rate then the real interest rate will be negative. If the economy is in deflating interest rate environment ie if the rate of inflation is decreasing over time than the real rate can also be negative. This is important to understand as inflation decreases the purchasing power and erodes capital.
- Bonds usually quote fixed rates also known as coupon payments. These rates are fixed and are not affected by the expectations or rate of inflation. For example, a $1000 bond has a rate of 5% which means that the issuer will pay $500 to the bondholder at every fixed period. If the investors expect any change in the rate of inflation ie if the investors feel that the rate of inflation is going to increase then they may opt for TIPS which are linked to inflation or bonds with a floating rate.
- To give it as an example, assume that X has deposited $1000 in your account. The interest rate for the account is 3%. This means that the balance of the account at the end of the year should be around $1030. This implies that the interest earned is $30. The annual interest rate, in this case, is 3%. However, this does not imply that you are $30 richer as we have not considered the rate of inflation. This is where the real rate of interest comes into the picture.
- Now assuming that the overall price in the economy has increased by 1%. This means that your money invested is worthless now than what it was earlier. Your buying power is eroded as you will now need additional money to buy the same product than you did a year ago. Therefore, to understand how much you have exactly benefited you have to adjust it for the rate of inflation. In our example, the rate of inflation is 1% and the nominal rate was 3%, therefore the effective real rate of interest is 2%. This means that your actual buying capacity is increased by 2%.
Nominal vs Real Interest Rate Comparative Table
|Basis||Nominal Rate||Real Rate|
|Formula||Nominal Rate = Real Rate + Inflation||Real Rate = Nominal Rate – Inflation|
|Definition||Nominal Rate is the simplest form of the rate which does not take inflation into account||Real rates are interest rates that have been adjusted to take into account the financial ripples caused by inflation|
|Inflation effect||They do not have any effect of inflation||When inflation is greater than the nominal rate the real rate will be negative and when the inflation is less than the nominal rate the real rate will be positive.|
|Investment Option||Bonds usually quote nominal rates. This type of rates is usually quoted as coupon rate for fixed income investments as this rate is the interest rate promised by the issuer that is stamped on the coupon to be redeemed by bondholders||Investors who want to seek protection from inflation invest in Treasury Inflation-Protected Securities (TIPS), the interest of these securities is indexed to inflation. There are also mutual funds available that invest in bonds, mortgages, and loans that are linked to the floating interest rate which are adjusted with current rates|
|Example||The rate of a Deposit is given as 2% p.a. on a $1000 investment. In nominal terms, the investor thinks that he is going to receive $200 as interest.||The rate of a Deposit is given as 2% p.a. on a $1000 investment and the rate of inflation is 3%. The actual percentage return the investor is going to earn is
2% – 3% = -1%. The return after considering the rate of inflation is negative.
Understanding interest rates are important as they will help evaluate and compare different investments and loans over time. In economics, nominal and real interest rates are two important concepts. GDP (Gross domestic product) of a country is quoted in nominal as well as real interest rate terms.
The Fisher equation as stated above helps in determining this rate precisely. The nominal rate describes the interest rate without any correction for the effects of inflation and the real interest rate refers to the interest rate adjusted for the effects of inflation.
This has been a guide to the Nominal Interest Rate vs Real Interest Rate. Here we discuss the top 5 differences between nominal and real interest rates along with infographics and comparison table. You may also have a look at the following articles –