Question

Explain the difference between nominal and real interest rates. Explain the process you would need to follow to determine the nominal interest rate and the real interest rate if you were considering buying a five-year bond with quoted annual interest rate of 4.5%

Answer 1

Nominal Interest Rate - This is the actual interest rate on the bond,share or loan that is beign purchased. It generally remains constant. It doesn't include any consideration of the real world conditions like inflation or market change.

So for example, if your interest rate mentioned in 5% and the economy is doing good or bad, it still stays 5%.

Real Interest Rate - This is the real interest rate,which takes into account the market conditions, or in simple terms may vary with the economy. If we have a higher inflation, it may even get negative. It is more practical parameter to consider as a buyer/borrower to understand the real amount you might need to pay.

As a rule of thumb nominal and real interest rate are related as-

Real Interest Rate (Real Rate of return) = Nominal Interest Rate - Inflation rate

For buying a five year bond with quoted annual interest rate of 4.5%. Let your initial loan be of $100.

In 5 years you might be paying $124 if you only consider the nominal rate.

If you consider the normal inflation rate of 1.4% in US for the same $100

In 5 years you will in reality be paying only $116.49

This difference could be explained as the increase of prices of things and purchasing power over the years.