Type of interest rate: nominal and real

The nominal interest rate is the stated interest rate. If a bank pays 5% annually on a savings account, then 5% is the nominal interest rate. So if you deposit $100 for 1 year, you will receive $5 in interest. However, that $5 will probably be worth less at the end of the year than it would have been at the beginning. This is because inflation lowers the value of money. As goods, services, and assets, such as real estate, rise in price, it takes more money to buy them.

Irving Fisher looked at interest rate equilibrium as the desire for a specific real rate of return plus the expected inflation rate:

Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate.

If the expected inflation rate was high, then people would demand a higher nominal rate for their investments; for why would anyone invest if they did not expect a real return? Although no one can really know what future interest rates will be, the nominal interest rate can be somewhat indicative of the expected interest rates.

The real interest rate is the nominal rate of interest minus inflation, which can be expressed approximately by the following formula:

Real Interest Rate = Nominal Interest Rate – Inflation Rate = Growth of Purchasing Power.

Real Interest Rate Formula

R = N - I

1 + I R = Real Interest Rate

N = Nominal Interest Rate

I = Inflation Rate

Because people invest to earn more purchasing power, they will only invest or lend money that pays more than the expected inflation rate. In this case, the nominal rate equals the real interest rate plus the expected inflation.