REAL AND NOMINAL RATE OF INTEREST BY DR

REAL AND NOMINAL RATE OF INTEREST BY DR KASHIF SALEEM

REAL INTEREST RATE • The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate. For example, if a loan has a 12 percent interest rate and the inflation rate is 8 percent, then the real return on that loan is 4 percent.

NOMINAL INTEREST RATE • Nominal interest rate is the interest rate which includes the effect of inflation. It approximately equals the sum of real interest rate and inflation rate. • Loans and investments mostly quote a nominal interest rate because it is the rate which is applied to the principal balance to arrive at interest expense. However, it is not the actual cost borne by the borrower. Since inflation erodes the value of money, the real maturity value of loan decreases with inflation. This results in a much lower real interest rate. Nominal interest rate overstates the cost of money for the borrower and rate of return for the lender.

REAL INTEREST RATE • Real interest rate 1. Interest rate that is adjusted for expected changes in the price level • ir=i−πe • 1. Real interest rate more accurately reflects true cost of borrowing • 2. When the real rate is low, there are greater incentives to borrow and less to lend

REAL INTEREST RATE • ir=i−πe • We usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation. After the fact, we can calculate the ex post real rate based on the observed level of inflation

THE FISHER EFFECT MONEY GROWTH AND INFLATION 7 • Rearrange the definition of the real interest rate: Nominal Real Inflation + = interest rate § The real interest rate is determined by saving & investment in the loanable funds market. § Money supply growth determines inflation rate. § So, this equation shows how the nominal interest rate is determined.

THE FISHER EFFECT MONEY GROWTH AND INFLATION 8 Nominal Real Inflation + = interest rate § In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate. § So, the nominal interest rate adjusts one-for-one with changes in the inflation rate. § This relationship is called the Fisher effect after Irving Fisher, who studied it.

18% The close relation between these variables is evidence for the Fisher effect. 15% 12% 9% Nominal interest rate 6% 3% Inflation rate 0% -3% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

THE FISHER EFFECT & THE INFLATION TAX MONEY GROWTH AND INFLATION 10 Nominal Real Inflation + = interest rate § The inflation tax applies to people’s holdings of money, not their holdings of wealth. § The Fisher effect: an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged.

THE COSTS OF INFLATION MONEY GROWTH AND INFLATION 11 • The inflation fallacy: most people think inflation erodes real incomes. • But inflation is a general increase in prices of the things people buy and the things they sell (e. g. , their labor). • In the long run, real incomes are determined by real variables, not the inflation rate.