Question

What is the real rate of interest? Differentiate it from the nominal rate of interest for the risk-free asset, a 3-month U.S. Treasury Bill.

Answer 1

Real Rate of Interest :

A real interest rate is the interest rate that takes inflation into account. To find the real interest rate, we take the nominal interest rate and subtract the inflation rate. For example, if a loan has a 12 percent interest rate and the inflation rate is 8 percent, then the real return on that loan is 4 percent. In calculating the real interest rate, we used the actual inflation rate.

Nominal Interest Rate :

A nominal interest rate refers to the interest rate before taking inflation into account. It is the interest rate quoted on bonds and loans. If you borrow $100 at a 6 percent interest rate, you can expect to pay $6 in interest without taking inflation into account.

Short-term nominal interest rates are set by central banks. These rates are the basis for other interest rates that are charged by banks and other institutions to consumers.

For a 3-month U.S. Treasury bill, the nominal rate of interest can be stated as r1r* IP. The default risk premium (RP) is assumed to be zero since the security is backed by the U.S. government; this security is commonly considered the risk-free asset.

Difference between Real Interest and Nominal Interest Rates :

• A real interest rate is adjusted to remove the effects of inflation and gives the real rate of a bond or loan.
• A nominal interest rate refers to the interest rate before taking inflation into account.
• To calculate the real interest rate, you need to subtract the actual or expected rate of inflation from the nominal interest rate.