Nominal Interest Rate

The nominal interest rate is the rate of interest before adjusting for inflation. It represents the percentage increase in money that the borrower pays to the lender, and it does not account for the decrease in purchasing power due to inflation.

Understanding Nominal Interest Rate

The nominal interest rate is crucial in finance as it directly affects borrowing costs and investment returns. Here are some key aspects:

• Basic Definition: The nominal interest rate is the stated interest rate on a loan, credit, or investment, not adjusted for inflation.
• Inflation Impact: It does not consider the eroding effect of inflation on the purchasing power of money over time.
• Comparison with Real Interest Rate: The real interest rate adjusts the nominal rate for inflation, providing a clearer picture of the actual cost of borrowing or the real return on an investment.

Calculation of Nominal Interest Rate

While the nominal interest rate itself is typically given, it can be derived from the real interest rate and the inflation rate using the Fisher equation:

• Fisher Equation: (1 + nominal rate) = (1 + real rate) × (1 + inflation rate)
• Alternatively, in an approximate form: nominal rate ≈ real rate + inflation rate

Example of Nominal Interest Rate

Suppose you are considering a savings account that offers a nominal interest rate of 5% per annum. If you deposit $1,000 in the account, at the end of one year you would earn:

• Interest Earned = Principal × Nominal Interest Rate
• Interest Earned = $1,000 × 0.05 = $50

At the end of the year, your total amount would be:

• Total Amount = Principal + Interest Earned
• Total Amount = $1,000 + $50 = $1,050

Now, if the inflation rate during that year was 2%, the real interest rate would be calculated as follows:

• Real Rate ≈ Nominal Rate – Inflation Rate
• Real Rate ≈ 5% – 2% = 3%

This illustrates that while you earned a nominal interest of 5%, the actual increase in your purchasing power was only 3% after adjusting for inflation. Understanding the difference between nominal and real interest rates is key to making informed financial decisions.