4.2 - Nominal v. Real Interest Rates
The Problem with Nominal Rates
A nominal interest rate is just the rate on a loan before you adjust for inflation. “Nominal” literally means “existing in name only.” Just like nominal GDP or nominal wages, a nominal interest rate on its own doesn’t tell you much, because it ignores inflation, which is honestly the most important part of the story. Nominal rates get set by supply and demand.
Real Interest Rates
What both borrowers and lenders actually care about is the real interest rate, which factors in inflation.
Expected real interest rate (ex ante): this uses the inflation rate that people expect going into the loan.
For example, if the nominal rate is 5% and expected inflation is 4%, the expected real rate is 1%.
Actual real interest rate (ex post): this can only be calculated after the fact, once you know what inflation actually turned out to be.
If inflation ends up higher than expected, that’s actually good news for borrowers, since it lowers the real interest rate they end up paying.
For example, a bank lends at 5% and expects 4% inflation, so it expects a 1% real return. If inflation actually turns out to be 6%, the actual real interest rate is 5% − 6% = −1%. The borrower pays back dollars that buy less than the dollars they borrowed, so the borrower wins and the bank loses. If inflation turns out to be only 2% instead, the actual real rate is 5% − 2% = 3%, and the bank comes out ahead.
Why Inflation Expectations Matter
What people expect inflation to be is really what sets the nominal interest rate. Borrowers and lenders both care about the real rate, and if nothing else changes, that real rate should stay pretty stable. So if expected inflation jumps, say from 4% to 14%, the nominal rate has to rise too (from 5% to 15%) just to keep that same 1% real rate. Even though the nominal number looks way higher, nothing has actually changed in real terms.
In formula form, it’s the expected real rate formula from above, flipped around. Lenders and borrowers agree on the real rate they want, add the inflation they expect, and the sum is the nominal rate they put on the loan:
For example, if a lender wants a 3% real return and expects 2% inflation, it charges a nominal rate of 3% + 2% = 5%.
Bottom line: the nominal rate is kind of misleading since it ignores inflation. What actually matters economically is the real rate. Because everyone’s really focused on the real return, rising inflation expectations push nominal rates up to compensate.