Question

Question 3

A) Please define real versus nominal interest rates. Do we using see figures in the press stated in nominal or real terms? When expected inflation is positive, is nominal inflation greater than or less than real? What if expected inflation is negative, what happens to the relationship?

B) The relationship between nominal and real interest rates continues to hold when there is deflation rather than inflation, except the overall change in prices is now negative. For example, take the case where the desired real interest rate is 3%., the expected deflation rate is -2%, and the actual deflation rate is -3%. What is the nominal interest rate? The actual real interest rate? If the reduction in prices is greater than expected, do borrowers or lenders benefit? Explain.

Answer 1

Simply put, nominal interest rates are rates quoted in something like your loan agreement. Another example is that it is the amount on my (for example) mortgage agreement which I have agreed to actually pay.

Conversely, with an increase in time, the prices will increase due to inflation and the purchasing power of my money will reduce. Substracting this loss of purchasing power from my nominal interest rate will give me my real interest rate on my loans, borrowings, etc.

Figures are given in real terms. Nominal Value does not specify how much difference there is in price levels. Real value removes this vagueness.

Where the inflation rate is higher than nominal interest rates, real interest rates are negative, and your savings fall in value according to what you can buy for them. When inflation is lower than the nominal interest rate the real value of your savings increases.

If my desired real interest rate is 3%, expected deflation rate is -2% and actual deflation rate is -3%:

Nominal Interest Rate is: 3% and if I reduce 2% from it to get my answer as 1%. This is my nominal interest rate.

However, my actual real interest rate is 3% - (-3%) = 6%

I have taken -3% as it is the actual deflation rate which will be in negative and when I minus two negatives, my answer will be in positive.

For the last part of (B)

For example, you lent $100 to a person and the interest rate that you are charging is 3%. This means that, you are going to get $103 after an year.

Now, let us suppose that inflation rate during the same year reaches 5%.

Therefore, a basket of goods which can be bought today at $100 would not be affordable at $103 after an year as you’ll need $105 to buy that. Lender loses his purchasing power.

However, the borrower gets benefitted. Say, he buys a television worth $100 with the money he borrowed. Now, due to inflation, price of television increases to $105. But, he just has to pay back $103 to the lender. Therefore, he is in a benefit of $2.

That’s how we can explain on why a lender looses out and borrower benefits in case of inflation. Vice Versa situation in case of a deflation situation.