Oct/07

23

# Norminal Interest Rate and Real Interest Rate

Today in my economy class I learn Norminal Interest Rate and Real Interest Rate.

The nominal interest rate (unadjusted for inflation) includes compensation for the lender’s lost value due to inflation, whereas the real interest rate excludes inflation. The real interest rate therefore expresses the cost of borrowed funds after the expected erosion of the value of those funds due to the rise in the general price level.

The relationship between real and nominal interest rates can be described in the equation:

(1 + r)(1 + i) = (1 + R) where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate.
A common approximation for the real interest rate is:
real interest rate = nominal interest rate – expected inflation
In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.

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