Nominal and real interest rate is Level of real interest rates

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:43

The most important characteristic of the modern economy is the depreciation of investments through inflationary processes. This fact makes it expedient to use not only the nominal, but also the real interest rate when making certain decisions in the loan capital market. What is the rate of interest? What does it depend on? How to determine the real interest rate?

The concept of the interest rate

The interest rate should be understood as the most important economic category, reflecting the profitability of any asset in real terms. It is important to note that it is the interest rate that plays a decisive role in the process of making managerial decisions, because any economic entity is very interested in obtaining the maximum level of revenue at minimum cost in the course of its activities. In addition, each entrepreneur, as a rule, reacts to the dynamics of the interest rateindividually, because in this case the determining factor is the type of activity and the industry in which, for example, the production of a particular company is concentrated.

Thus, owners of capital funds are often only willing to work if the interest rate is marginally high, and borrowers are likely to buy capital only if the interest rate is low. The above examples are clear evidence that today it is very difficult to find a balance in the capital market.

Interest rates and inflation

The most important characteristic of a market economy is the presence of inflation, which leads to the classification of interest rates (and, of course, the rate of return) into nominal and real. This allows you to fully evaluate the effectiveness of financial operations. If the inflation rate exceeds the interest rate received by the investor for investments, the result of the corresponding operation will be negative. Of course, in terms of absolute value, his funds will increase significantly, that is, for example, he will have more money in rubles, but the purchasing power that is characteristic of them will fall significantly. This will lead to the opportunity to buy only a certain amount of goods (services) for the new amount, which is less than it would have been possible before the start of this operation.

Distinctive features of nominal and real rates

As it turned out,nominal and real interest rates differ only in conditions of inflation or deflation. Inflation should be understood as a significant and sharp increase in prices, and under deflation - their significant fall. Thus, the nominal rate is considered to be the rate set by the bank, and the real interest rate is the purchasing power inherent in income and denoted as interest. In other words, the real interest rate can be defined as the nominal rate, which is adjusted for the inflationary process.

Irving Fisher, an American economist, has formed a hypothesis that explains how the level of real interest rates depends on nominal ones. The main idea of the Fisher effect (this is how the hypothesis is called) is that the nominal interest rate tends to change in such a way that the real one remains “fixed”: r (n) u003d r (p) + i. The first indicator of this formula reflects the nominal interest rate, the second - the real interest rate, and the third element is equivalent to the expected rate of inflationary processes, expressed as a percentage.

The real interest rate is…

A striking example of the Fisher effect, discussed in the previous chapter, is the picture when the expected pace of the inflationary process is equal to one percent per annum. Then the nominal interest rate will also rise by one percent. But the real percentage will remain unchanged. This proves that the real interest rate is the same as the nominal interest rate minusestimated or actual inflation rates. This rate is fully adjusted for inflation.

Calculation of the indicator

The real interest rate can be calculated as the difference between the nominal interest rate and the level of inflation processes. Thus, the real interest rate is equal to the following ratio: r(p)=(1 + r(n)) / (1 + i) - 1, where the calculated indicator corresponds to the real interest rate, the second unknown member of the ratio determines the nominal interest rate, and the third element characterizes the rate of inflation.

Nominal interest rate

When talking about lending rates, as a rule, we are talking about real rates (the real interest rate is the purchasing power of income). But the fact is that they cannot be observed directly. Thus, when concluding a loan agreement, an economic entity is provided with information on nominal interest rates.

Under the nominal interest rate should be understood the practical characteristics of interest in quantitative terms, taking into account current prices. The loan is issued at this rate. It should be noted that it cannot be greater than or equal to zero. The only exception is a loan on a free basis. The nominal interest rate is nothing more than the percentage expressed in monetary terms.

Calculate the nominal interest rate

Let's say that in accordance with the annual loan of ten thousand monetary units, 1200 monetary units are paidunits as a percentage. Then the nominal interest rate is equal to twelve percent per annum. After receiving a loan of 1200 monetary units, will the lender get rich? A competent answer to this question can only be known exactly how prices will change during the annual period. Thus, with an annual inflation rate of 8 percent, the lender's income will increase by only 4 percent.

The nominal interest rate is calculated as follows: r=(1 + percentage of income received by the bank)(1 + inflation rate increase) – 1 or R=(1 + r) × (1 + a), where the main indicator is the nominal interest rate, the second is the real interest rate, and the third is the growth rate of the inflation rate in the corresponding country.

Conclusions

There is a close relationship between nominal and real interest rates, which for absolute understanding it is advisable to present as follows:

1 + nominal interest rate=(1 + real interest rate)(price level at the end of the considered time period / price level at the beginning of the considered time period) or 1 + nominal interest rate=(1 + real interest rate)(1 + rate of inflationary processes).

It is important to note that only the real interest rate reflects the real effectiveness and productivity of transactions made by an investor. It says about the increase in the purchasing power of the funds of a given economic entity. The nominal interest rate candisplay only the value of the increase in cash in absolute terms. It does not take into account inflation. An increase in the real interest rate indicates an increase in the purchasing power of the currency. And this is equal to the opportunity to increase consumption in future periods. This means that this situation can be interpreted as a reward for current savings.