Real vs. Nominal Interest Rates

Interest is measured in dollar terms, not in terms of houses or cars or goods in general. The nominal interest rate measures the yield in dollars per year per dollar invested. But dollars can become distorted yardsticks. The prices of houses, cars, and goods in general change from year to year-these days prices generally rise due to inflation. Put differently, the interest rate on. dollars does not measure what a lender really earns, in terms of goods and services. Let us say that you lend $100 today percent-per-year interest. You would get back $105 at the end of a year. But because prices changed over the year, you would not be able to obtain the same quantity of goods that you could have bought at the beginning of the .year if you had $105.

During inflationary periods, we must use real interest rates, not nominal or money interest rates, to calculate the yield on investments in terms of goods . earned per year on goods invested. The real interest rate is approximately equal to the nominal interest rate minus the rate of inflation.

The difference between nominal and real interest rates is illustrated in Figure 25-3. It shows that most of the rise in nominal interest rates from 1960 to 1980 was purely illusory for nominal interest rates were just keeping up with inflation during those years. After 1980, however, real interest rates rose sharply and remained high for a decade

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