Question

5. Explain Nominal Rate, Real Rate, and the relationship between these two rates. Please use a real life example to demonstrate when to use a nominal rate, when to use a real rate.

Answer 1

A nominal interest rate is the interest rate that does not take inflation into account it is the interest rate that is quoted on books and loans as opposed to the nominal interest rate the real interest rate adjust from inflation and gives the real rate of the born alone. The relationship between nominal rate and real rate is generally opposite in nature. Nominal interest rate is the interest rate that does not take inflation into account it is the interest rate that is quoted on bonds and loans the nominal interest rate is a simple concept to understand for example if someone borrows dollar 100 at a 6% interest rate that person can expect to pay dollars 6 in interest without taking inflation into account the disadvantage of using the nominal interest rate is that it does not adjust for inflation rate a real interest rate is the interest rate that does take inflation into account as opposed to nominal interest the real interest rate adjust from the inflation and this the real rate of born alone to calculate the real interest rate somebody first needs the calculation used to find the real interest rate is the nominal interest rate minus the expected and actual inflation rate that gives the real rate that lenders Are investors are receiving after inflation is factor in it gives them a better idea of the rate at which their purchasing power is increasing or decreasing. nominal interest rate. For example suppose a bank loans a person $200,000 to purchase a house at 3% rate the 3% is the nominal interest rate not factoring for inflation assuming the inflation rate is 2% the real interest rate the borrower is paying is 1% the real interest rate the bank is receiving is 1% the purchasing power of the bank only increases by 1%.. another example of nominal annual interest rate is 12% based on monthly compounding means 1% interest rate per month compounded and nominal interest rate for compounding periods less than 1 year is always lower than equivalent race with annual compounding a nominal rate without the compounding frequency is not fully defined for any interest rate the effective interest rate cannot be specified without knowing the compounding frequency and the rate although some conventions are used where the compounding frequency is understood consumers in particular may fail to understand the importance of knowing the effective rate normal rates and not compatible unless their compounding periods are same.

The nominal interest rate is the simplest type of interest rate it is stated interest rate of given Bond alone the nominal interest rate is the actual monetary price that was failed to lenders to use their money if the nominal rate on loan is 5% then borrowers can expect to pay $5 open interest for every $100 loan to them but nominal interest does not take inflation into account now imagine that the inflation rate was 5% of 5% relation break means that an average basket of goods are purchased during the year is 5% more expensive when compared to last year continuing with our Christmas example the lenders would make nothing if he loaned it out at 5% when the rate of inflation was 5%. Effective and nominal interest rates allowed banks to use number that looks more advantages to consumer when banks are charging interest day ad advertise the nominal rate which is lower and does not reflect how much interest the consumer goods on the balance after a full here of compounding on the other hand with deposit accounts where dance the pain in breast naturally at was the effect rate because it is higher than the nominal rate therefore if you wear to borrow money at 8% APR and immediately deposit it in an account at 8% a APY the deposit account will have less money at the end of the year that you owe on the debt.