Question

Could you explain the relationship between the real interest rate, nominal interest rate, and inflation rate? How can we get the approximate value of the real interest rate (show the formula)? Could you also give me a real-life example to show this relationship?

Subject: Finance

Answer 1

Answer to Part (1)

The Relationship between Real Rate, Nominal Rate and Inflation rate is as mentioned below:

Real Rate is what is desired by the investor or lender as a percentage of return on investment, the inflation rate is earning lost sue to inflation in the economy, So in this case, the inventory or lender will charge an interest rate that will be a combination of Real Interest Rate and Inflation Rate know as the Nominal rate.

Nominal rate = Real Interest Rate + Inflation rate

Answer to Part (2)

Real Interest Rate = Nominal Interest Rate - Inflation Rate

Answer to Part (3)

Let's take an example of a bank, HDFC bank wants to earn a real interest rate of 5.45% to their earnings, the inflation rate during the year will be 2%, So what should the bank charge from their customer?

Bank should Charge Nominal Interest Rate of 6.45% i.e Real Interest Rate + Inflation Rate. This is what will give the bank a return of 4% on their earnings after deducting the inflation during the year.