# REAL AND NOMINAL INTEREST RATES

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REAL AND NOMINAL INTEREST RATES

• Zero; inflation: If the price of a CD remains at \$10, the amount she can buy has risen from 100 to 110 CDs. The 10 percent increase in the number of dollars means a 10 percent increase in her purchasing power

• Six percent inflation: If the price- of a CD rises from \$10 to \$10.60, then the number of CDs she can buy has risen from 100 to approximately 104. Her purchasing power has increased by about 4 percent.

• Ten percent inflation: If the price of a CD rises from \$10 to \$11, then even though Sally’s dollar wealth has risen from \$1,000 to \$1,100, she can still buy only 100 CDs. Her purchasing power is the same as it was a year earlier.

• Twelve percent inflation: If the price of a CD increases from \$10 to \$11.20, then even with her greater number of dollars, the number of CDs she can has fallen from 100 to approximately 98. Her purchasing power has decreased by about 2 percent.

. Two percent deflation: If the price of a CD falls from \$10 to \$9.80, then the number of CDs she can buy rises from 100 to approximately 112. Her purchasing power increases by about 12 percent.

These. examples show that the higher the rate of inflation, the smaller the increase in Sally’s purchasing power. If the rate of inflation exceeds the rate of interest, her purchasing power actually falls. And if there is deflation (that is, a negative rate of inflation), her purchasing power rises by more than the rate of interest. To understand how much a person earns in a savings account, we need to consider both the interest rate
and the change in the prices. The interest rate that measures the change in dollar amounts is called the nominal interest rate, and the interest rate corrected for inflation is called the real interest rate. The nominal interest rate, the real interest rate, and inflation are related approximately as follows,

Real interest rate = Nominal interest rate – Inflation rate.

The real interest rate is the difference between the nominal interest rate and the rate of inflation. The nominal interest rate tells you how fast the number of dollars in your bank account rises over time. The real interest rate tells you how fast the purchasing power of your bank account rises over time.

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