16. Explain the difference between nominal and real interest rates. interest rates are the stated rates of interest. The ( nominal rates corrected for the effects of inflation on the interest payments. The high real rate represents the decrease in purchasing power that the lender receives from the borrower and can be approximated by ( adding, subtracting ) the rate of inflation from the nominal rate of interest. interest rates are the That is, approximately, Real Interest Rate = Nominal Interest - Inflation Rate. How does inflation explain differences between nominal and real interest rates? A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates are approximately %.
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.
A real interest rate is the interest rate that takes inflation into account. This means it adjusts for inflation and gives the real rate of a bond or loan. To calculate the real interest rate, you first need the nominal interest rate. The calculation used to find the real interest rate is the nominal interest rate minus the actual or expected inflation rate.
Suppose a bank loans a person $200,000 to purchase a house at a rate of 3%-the nominal interest rate not factoring in inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%. The real interest rate the bank is receiving is 1%. That means the purchasing power of the bank only increases by 1%.
The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in inflation. This also gives them a better idea of the rate at which their purchasing power increases or decreases. They can estimate their real rate of return by comparing the difference between a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) yield of the same maturity, which estimates inflation expectations in the economy.
Step by step
Solved in 3 steps
