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.

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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 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.read more is simply the sum of the real interest rateReal Interest RateReal interest rates are interest rates calculated after taking inflation into account. It is a means of obtaining inflation-adjusted returns on various deposits, loans, and advances, and thus reflect the real cost of funds to the borrower. read more and 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 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.read more.

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.

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 economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more.

Nominal Interest Rate vs Real Interest Rate Infographics

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

Nominal vs Real Interest Rate Comparative Table

Conclusion

Understanding interest rates are important as they will help evaluate and compare different investments and loansLoansA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more 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.

This article guides Nominal vs Real Interest Rate. Here we discuss the top difference between nominal and real interest rate with infographics and a comparison table. You may also have a look at the following articles: –

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