REAL AND NOMINAL INTEREST RATES

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REAL AND NOMINAL INTEREST RATES

Correcting economic variables for the effects of inflation is particularly important, and somewhat tricky, when we look at data on interest rates. The very concept of an interest rate necessarily involves comparing amounts of money at different points in time. When you deposit your savings in a bank account, you give the bank some money now, and the bank returns your deposit with interest in the future. Similarly, when you borrow from a bank, you get some money now, but you will have to repay the loan with interest in the . In both cases, to fully understand the deal between you and the bank, it is crucial to acknowledge that future dollars may have different value from current dollars. That is, you have to correct for the effects of inflation Let’s consider an example. Suppose that Sally Saver deposits $1,000 in a bank account that pays an annual interest rate of 10 percent. A year later, after Sally has accumulated $100 in interest, she withdraws her $1,100. Is Sally $100 richer than she was when she made the deposit a year earlier? The answer depends on what we mean by “richer.” Sally does have $100 more than she had before. In other words, the number of dollars in her possession has risen by 10 percent. But Sally does not care about the amount of money itself: She cares about what she can buy with it. If prices have risen while her money was in the bank., each dollar now buys less than it did a year ago. In this case, her purchasing power-the amount of goods and services she can buy-has not risen by 10 percent. To keep things simple, let’s suppose that Sally is a music fan and buys only music CD When Sally made her deposit, a CD at her local music store cost $10. Her  of $1,000 was equivalent to 100 CDs. A year later, after getting her 10 percent interest, she has $1,100. How many CDs can she buy now? It depends on what has happened to the price of a CD. Here are some examples.

• 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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REAL AND NOMINAL INTEREST RATES