Nominal Versus Real Interest Rates

A nominal interest rate is the rate you actually see quoted: 6 percent on a savings account, 7 percent on a loan. But that number doesn't tell you what you really gain, because prices are moving too. If your savings grow 6 percent but prices rise 5 percent over the same year, your money buys only about 1 percent more stuff than before. That leftover gain in purchasing power is the real interest rate, and it's what actually matters for deciding whether saving or lending is worth it.

The mechanism is simple subtraction: real interest rate equals nominal interest rate minus inflation rate. This is an approximation, but it's the one used throughout this course, and it works well when rates and inflation are both small. So a lender who writes 7 percent on a loan contract isn't guaranteed to earn 7 percent in real terms. If inflation runs at 4.5 percent that year, the lender's real return is only about 2.5 percent, because inflation quietly eats into the value of every dollar paid back.

This idea connects directly to the two interest rates set earlier in the unit: the money market sets the nominal rate through supply and demand for money, while the loanable funds market is best understood in real terms, since savers and borrowers care about purchasing power, not the sticker rate. Expected inflation is what shifts loanable funds supply and demand, linking the nominal and real sides of the financial sector together.