Practice
Real and nominal interest rates
The real interest rate from the nominal rate and inflation, and the nominal rate lenders set from what they expect.
The skill
The nominal interest rate is the rate written on the loan, and the real rate takes inflation out of it. Lenders and borrowers set the nominal rate as the real rate they expect plus the inflation they expect. Looking back, the real rate is the nominal rate minus the inflation that actually happened, and it can be negative. Check whether the question gives expected or actual inflation, and whether you are building a nominal rate up or taking a real rate out of one.
A worked example
A one-year loan was made at a nominal interest rate of 5.7%. Over the year, the inflation rate turned out to be 4.5%.
What was the real interest rate on the loan, as a percent? Give a negative number if it is negative.
Solution
- Real interest rate = nominal rate − actual inflation = 5.7 − 4.5 = 1.2%.
- Inflation took part of the nominal return away.
Answer: 1.2%