# Nominal vs Real Interest Rate

Published on :

21 Aug, 2024

Blog Author :

Wallstreetmojo Team

Edited by :

N/A

Reviewed by :

Dheeraj Vaidya

## Difference Between Nominal and Real Interest Rate

The nominal rate is the rate of return which considers the monetary value but neglects inflation during calculation. In contrast, the real rate includes computation inflation and thus provides investors with transparency by reflecting the opportunity value.

We can understand the difference between nominal and real interest rates 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.

Nominal Interest Rate = Real Interest Rate + Expected Inflation

The idea behind the Fisher effect is that real rates are relatively stable, and changes in expected inflation drive changes in interest rates. It is consistent with money neutrality.

However, investors are exposed to the risk that inflation and other future outcomes may differ from expected. Therefore, investors require an additional return (a risk premium) to bear this risk, which we can consider the third component of a nominal interest rate.

Nominal Interest Rate Formula = Real Interest Rate + Expected Inflation + Risk Premium

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 us see the top differences between nominal and real interest rates.

### Conclusion

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. A country's GDP (Gross Domestic Product) is quoted in nominal and real interest rate terms.

As stated above, the Fisher equation helps in determining this rate precisely. The nominal rate describes the interest rate without any correction for the effects of inflation. The real interest rate refers to the interest rate adjusted for the impact of inflation.

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