Nominal vs Real Interest Rate

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Difference Between Nominal and Real Interest Rate

The nominal rate is the rate of return which considers the monetary value but neglects inflation during calculation. In contrast, the real rate includes computation inflation and thus provides investors with transparency by reflecting the opportunity value.

Difference Between Nominal and Real Interest Rate

We can understand the difference between nominal and real interest rates with the help of the Fisher equation. The Fisher effect states that the nominal interest rate is simply the sum of the real interest rate and expected inflation.

Nominal Interest Rate = Real Interest Rate + Expected Inflation

The idea behind the Fisher effect is that real rates are relatively stable, and changes in expected inflation drive changes in interest rates. It is consistent with money neutrality.

However, investors are exposed to the risk that inflation and other future outcomes may differ from expected. Therefore, investors require an additional return (a risk premium) to bear this risk, which we can consider the third component of a nominal interest rate.

Nominal Interest Rate Formula = Real Interest Rate + Expected Inflation + Risk Premium

Essentially, the difference between these rates is inflation. It is important to understand these rates because nominal rates do not show the entire story for investment returns or the economy.

Nominal Interest Rate vs Real Interest Rate Infographics

Let us see the top differences between nominal and real interest rates.

Nominal vs Real Interest Rate Comparative Table

Basis	Nominal Rate	Real Rate
Formula	Nominal Rate = Real Rate + Inflation	Real Rate = Nominal Rate – Inflation
Definition	The nominal rate is the simplest rate that does not consider inflation.	The real rates are adjusted to evaluate the financial ripples caused by inflation.
Inflation effect	They are not impacted by inflation.	When inflation is greater than the nominal rate, the real rate will be negative, and when inflation is less than the nominal rate, the real rate will be positive.
Investment Option	Bonds usually quote nominal rates. This type of rate is generally cited as a coupon rate for fixed income investments as this rate is the interest rate promised by the issuer stamped on the coupon to be redeemed by bondholders.	Investors who want to seek protection from inflation invest in Treasury Inflation-Protected Securities (TIPS), the interest of these securities is indexed to inflation. In addition, mutual funds invest in bonds, mortgages, and loans linked to the floating interest rate, adjusted with current rates.
Example	A deposit rate is 2% p.a. on a $1,000 investment. The investor thinks he will receive $200 as interest in nominal terms.	The deposit rate is 2% p.a. on a $1,000 investment, and the inflation rate is 3%. The actual percentage return the investor is going to earn is 2% – 3% = -1%. The return after considering the rate of inflation is negative.

Conclusion

Understanding interest rates are important as they will help evaluate and compare different investments and loans over time. In economics, nominal and real interest rates are two important concepts. A country's GDP (Gross Domestic Product) is quoted in nominal and real interest rate terms.

As stated above, the Fisher equation helps in determining this rate precisely. The nominal rate describes the interest rate without any correction for the effects of inflation. The real interest rate refers to the interest rate adjusted for the impact of inflation.