Tuesday, August 18, 2009

the nominal and real interest rate

To examine the relationship between inflation and interest rate, several key terms must be defined. First, we must distinguish between nominal and real interest rates. The nominal rate is the published or quoted interest rate on a security or loans. For example, an announcement in the financial press that major commercial banks have raised their prime lending rate to 15 percent per annum indicates what nominal interest rate is now being quoted by banks to their most credit-worthy customers. In contrast, the real rate of interest is the return to the lender or investor measured in terms of its actual purchasing power. In a period of inflation, of course, the real rate will be lower than the nominal rate. Another important concept is the inflation premium, which measures the rate of inflation expected by investors in the marketplace during the life of financial instruments.
These three concepts are all related to each other. Obviously, a lender of funds is most interested in the real rate of return on a loan-that is, the purchasing power of any interest earned. For example, suppose you loan $1000 to a business firm or individual for a year and expect prices of goods and services to rise 10 percentages during the year. If you charge a nominal interest rate of 12 percent on the loan, your real rate of return on the $1.000 face amount of the loan is only 2 percentages, or $20. However, if the actual rate of inflation during the period of the loan turns out to be 13 percent, you have actually suffered a real decline in the purchasing power of the monies loaned. In general, lenders will attempt to charge nominal rates of interest which give them desired real rates of return on their loanable funds. And nominal interest rates will change as frequently as lenders alter their expectations regarding inflation

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