4.2 Nominal versus Real Interest Rates

Two ways to measure interest

The nominal interest rate is the stated rate on a loan or savings account, unadjusted for inflation. The real interest rate adjusts for inflation and reflects the true change in purchasing power. Real rates matter more for economic decisions because they show the actual cost of borrowing or reward for saving.

The Fisher Equation

The relationship is captured by the Fisher equation: real interest rate ≈ nominal interest rate − expected inflation rate. So if a bank pays 6% nominal interest and inflation is 4%, the real interest rate is about 2%. This shows lenders and borrowers care about real returns, not just nominal ones.

Why the distinction matters

Unexpected inflation redistributes wealth: if inflation rises above expectations, borrowers gain (paying back loans with cheaper dollars) and lenders lose (real return falls). If inflation is lower than expected, lenders gain and borrowers lose. Decisions about saving, investing, and borrowing are based on expected real rates, not nominal rates.

Key terms

Nominal interest rate

The stated interest rate on a loan or investment, not adjusted for inflation.

Real interest rate

The interest rate adjusted for inflation; reflects true change in purchasing power.

Fisher equation

Real interest rate ≈ nominal interest rate − expected inflation rate.

Effect of higher-than-expected inflation

Benefits borrowers (repay with cheaper dollars); hurts lenders (lower real returns).

Why real rates matter

They show the true cost of borrowing and true reward for saving, guiding economic decisions.

Try an AP-style question

What is the real interest rate?

1. 4%
2. 10%
3. 7%
4. 2.3%