Question

Define the nominal interest rate. How is the nominal interest related to the real interest rate? Why can we think of 1+ rt , where rt is the real interest rate, as the relative price of consumption today in terms of consumption in the future?

Answer 1

Nominal interest rate is the rate of interest without accounting for inflation. It refers to the advertised or stated rate of interest without considering any other fees, costs and inflation.

The Fisher's equation relates the nominal interest rate with the real interest rate, The equation is given as -

Real Interest Rate = Nominal Interest Rate - Inflation

Thus, the real interest rate adjusts for inflation.

Given the total amount of money is fixed, and assuming two time periods - present and the future, the consumer has to consume now or in the future. If he does not consume now, he will earn an interest of rt on the money. If the money is Y, then in period 2 he will have (1+rt)Y. However, if he decides to consume now, but he does not have money, again he will borrow Yat the rate rt. Thus. (1 + rt) is the price of consumption today in terms of consumption in the future period. It represents the opportunity cost.