Question

Could you explain the relationship among 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? (For example, recall the one I showed you about buying apples).

Answer 1

The nominal interest rate is the percentage increase in money you pay the lender for the use of the money you borrowed over a time.

Real interest rate is the percentage increase in money you pay the lender for the use of the money you borrowed over a time after adjusting the purchasing power erosion caused due to inflation.

Inflation refers to the rise in the prices of goods and services. Inflation measures the average price change in commodities and services over time.

Relationship among the real interest rate, nominal interest rate, and inflation rate:

As we know from above definition that unlike the nominal rate, the real interest rate adjust the inflation rate. When we remove the effect of inflation from nominal interest rate we get the real interest rate.

This relationship can be formulated as:

Nominal Interest Rate = Real Interest Rate + Inflation Rate

Real life example to show this relationship:

Suppose Mr. A earn interest rate of 20% yearly from a deposit of $100. Mr. A earning is $20 per year. Now suppose he only purchase 1kg apples throughout the year. Last year he purchased 1 kg apple of $10. But this year cost of apple rises 10% inflation rate and this year Mr. X purchased 5 kg apple of $11. Now in last 1 year the purchasing power of money reduces. Last year’s $10 purchasing power is now equal to $11 purchasing power.

Although Mr. A earned $20 in both years, but last year’s $20 was more valuable than this year $20. As last year $20 was able to purchase 2 kg of apple but this year $20 can only purchase 1.82 kg of apple.