How do you find the Real Interest Rate?
This is a really simple calculation:
Real Interest Rate = Nominal Interest Rate – Inflation
What we really need to distinguish here is how the “real interest rate” differs from the “nominal interest rate”, and “expected inflation” vs. “unexpected inflation”.
Here’s how I explain it. Banks set a NOMINAL interest rate, whether it’s for a loan or a savings vehicle. When you enter into a loan agreement or a savings agreement with a bank, you are setting up a NOMINAL interest rate. Let’s just focus on the interest rates for loans. When the banks set their interest rates they take EXPECTED inflation into consideration, we always expect a small amount of inflation. The banks are in the game to make money so their nominal interest rates are designed to cover expected inflation so that their REAL interest rates still brings in revenue. The problem (for the banks) is when we experience UNEXPECTED inflation.
Here’s an example: I go to the bank and get a loan. The bank knows that we usually EXPECT 2% inflation so they set my interest rate at 5% (nominal). The bank is REALLY going to get to keep 3% (5% nominal – 2% inflation) of my interest payments. But what if something happens and inflation UNEXPECTEDLY skyrockets to 6%?? Now the bank’s REAL interest rate is 5% – 6% = -1%. They are losing money on my loan! Unexpected inflation hurts the lender. But let’s talk about me (the one getting the loan). Inflation eats away at the value of your money. Regardless of what happens with unexpected inflation I still pay the same amount for my loan, 5%, my nominal interest rate. So if inflation skyrockets to 6%, I’m paying the bank back with money that is not worth as much as it was when I entered into the loan. This is great for me! Unexpected inflation helps the borrower.
AP Macro 4.2 Notes – FREEBIE!!
I’m offering these notes for free because they still have Time Value of Money on them. Time Value of Money is no longer required for the AP Macroeconomics Exam. You can have students write on hard copies, or they can fill them out digitally on Google Forms or Microsoft PowerPoint.
Wishing you all the best with those interest rates!