Real vs. Nominal Interest Rates and Changes in Prices

Real vs. Nominal Interest Rates and Changes in Prices
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  • 0:07 Evaluating Interest Rates
  • 1:31 Real vs. Nominal…
  • 2:56 The Fisher Equation
  • 6:23 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

This lesson explains the important difference between nominal and real interest rates and provides examples of how to use the Fisher equation to adjust nominal rates for inflation.

Evaluating Interest Rates

Please join me at The First National Bank of Ceelo, where Margie the Cake Baker already has a simple checking account that pays her basically no interest and wants to earn a higher rate. Why? Because she really wants to enlarge her kitchen, so she can have dessert parties and advertise her incredible cakes.

As you'll see, Dave the branch manager is going to offer her three different types of accounts: a money market account, a bond, and also a consumer loan. In this lesson, we're going to learn about the difference between nominal and real interest rates. We're also going to see how Margie can use a simple equation called the Fisher equation, using a few practice problems, to convert a nominal interest rate into a real interest rate, which is what she really needs to know to make a wise decision.

Dave offers her three options: a money market account that's paying 4% interest, a bond that's paying 5% interest, and a consumer loan that's charging her 8%. What Margie wants to do is adjust these rates by inflation so she can decide if they are a good deal. Let's begin by exploring two ways that economists look at interest rates.

Real vs. Nominal Interest Rates

When the bank publishes the interest rate for the money market account, they use the nominal rate. The nominal interest rate is the interest rate in terms of dollars, so it's not adjusted for inflation. Nominal simply means it has not been adjusted in any way - when you hear the word 'nominal,' just think nothing's been done to it - it's nominal. However, the rate that Margie really cares about is the real interest rate. The real interest rate is the rate of interest after adjusting for inflation. This year, Margie expects inflation to be 2%, let's say. This is what economists call expected inflation.

Why is the real interest rate the more important one? Because inflation reduces the purchasing power of money. When prices rise by, say, 2% this year, a bank account that pays 2% interest on one of their accounts is essentially paying nothing after accounting for the rise in prices in goods and services in the economy. Accounting for inflation tells you what you're really getting. This is sometimes called inflation-adjusted. The real interest rate is the 'what you see is what you get' version.

Economists have a simple equation, of course, to help us find the real interest rate, and it's called the Fisher equation.

The Fisher Equation

The Fisher equation is simply:

r = n - i

where r = the real interest rate, n = the nominal interest rate, and i = the expected rate of inflation.

So, we can say it this way: real interest rate = nominal interest rate - expected inflation.

Now Margie can evaluate the money market account and the other options that she's going to get from Dave the branch manager. So let's try a few problems and help her find the real interest rate using the Fisher equation.

Let's start with the money market account:

Since she expects inflation to be 2%, we can use the Fisher equation like this:

r = 4% - 2%, which equals 2%. This means that the money market she's been offered has a real interest rate of 2%.

Margie can use the Fisher equation on the bond as well. Using the Fisher equation, she calculates the real interest rate, as follows:

Remember, the nominal rate on the bond was 5%, so when we plug it into the Fisher equation, it looks like this:

r = 5% - 2% = 3%, so 3% is the real interest rate on this bond.

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