understanding real vs. nominal interest

REAL VS. NOMINAL INTEREST RATE

The term “interest rate” is one of the

most commonly used phrases in day to

day finance. Today we will cover - Real

vs. Nominal Interest Rates.

REAL INTEREST RATE VS. NOMINAL INTEREST RATE

Let us see the formula of the Current Account Balance (CAB)

CAB = X - M + NI + NCTX = Exports of goods and servicesM = Imports of goods and servicesNI = Net income abroad [Salaries paid or received,

credit / debit of income from

FII & FDI etc. ]

NCT = Net current transfers [Workers' Remittances

(unilateral), Donations,

Aids & Grants, Official,

Assistance and Pensions etc]

CURRENT ACCOUNT DEFICIT

The difference between nominal and

real interest rate is the key economic

factor – ‘Inflation’.


Inflation is a rise in the general price

level. For instance, a 6% inflation rate

means that an average basket of goods

you purchased this year is 6% more

expensive as compared to last year.



Real Interest Rate is one where the effects of inflation have been factored

in.

Nominal Interest Rate is one where the effects of inflation have not been

accounted for.

Let us consider an example to

illustrate the difference :



Suppose your fixed deposit of Rs. 100 earns 10% interest at the end of

the year.

This means the Rs. 100 at beginning of the year will become Rs. 110 at

the end of the year.

This 10% is the nominal interest rate, as we have not accounted for

inflation.




FII & FDI etc. ]






Whenever people speak of the

interest rate they're talking about the

nominal interest rate, unless they

state otherwise.


Assume that inflation rate is 6% for the year and your fixed deposit earns

10% nominal interest rate.

After factoring in inflation, your deposit will earn a real interest rate of 4%.


COMPARING REAL & NOMINAL INTEREST RATE


Nominal Interest Rate

= 10%

Inflation = 6%

Real Interest Rate = 4%




FII & FDI etc. ]






The relationship between nominal

interest rate, inflation, and real

interest rate is described by the

Fisher Equation:


Real Interest Rate = Nominal Interest Rate – Inflation

If inflation is positive, then the real interest rate is lower than the nominal

interest rate.

If we have deflation and the inflation rate is negative, then the real

interest rate will be larger.





FII & FDI etc. ]






Hope you have understood the

difference between Real and

Nominal Interest Rate.


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DISCLAIMER

The views expressed in this lesson are for information purposes only and do not construe to be

any investment, legal or taxation advice. The lesson is a conceptual representation and may not

include several nuances that are associated and vital. The purpose of this lesson is to clarify the

basics of the concept so that readers at large can relate and thereby take more interest in the

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perspective of it being a primer on financial concepts. The contents are topical in nature and

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understanding real vs. nominal interest

Economy & Finance