Difference Between Nominal and Real Interest Rate
The nominal rate is that rate of return which considers the monetary value but ignores inflation during calculation. In contrast, the real rate includes inflation for computation and thus provides transparency to the investors by reflecting the opportunity value.
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 rateNominal Interest RateNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans. 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 neutralityMoney NeutralityThe neutrality of money is a belief that any change in the supply of money has an impact on prices and wages while having no effect on total economic productivity..
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.
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 SecuritiesTreasury Inflation-Protected SecuritiesTreasury inflation-protected securities (TIPS) are inflation-indexed bonds issued by the US government. Since its principal is indexed to the US consumer price index, it provides a hedge to the inflation risk. With increasing inflation, TIPS's principal values also rise, hedging the bond's inflation risk. (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 –