REAL VS. NOMINAL INTEREST RATE

REAL INTEREST RATE VS. NOMINAL INTEREST RATE The term “interest rate” is one of the most commonly used phrases in day to day finance. Today we will cover Real vs. Nominal Interest Rates.

Let us see the formula of the Current Account Balance (CAB) CAB = X - M + NI + NCT

X = Exports of goods and services M = Imports of goods and services NI = Net income abroad

[Salaries paid or received, credit / debit of income from FII & FDI etc. ]

NCT = Net current transfers

[ Workers' Remittances Pensions etc]

factor – ‘ Inflation ’.

REAL INTEREST RATE VS. NOMINAL INTEREST RATE Inflation is a rise in the general price level. For instance, a 6% inflation rate means that an average basket of goods you purchased this year is 6% more expensive as compared to last year.

REAL INTEREST RATE VS. NOMINAL INTEREST RATE Real Interest Rate is one where the effects of inflation have been factored in. Nominal Interest Rate is one where the effects of inflation have not been accounted for.

REAL INTEREST RATE VS. NOMINAL INTEREST RATE Let us consider an example to illustrate the difference :

REAL INTEREST RATE VS. NOMINAL INTEREST RATE Suppose your fixed deposit of Rs. 100 earns 10% interest at the end of the year. This means the Rs. 100 at beginning of the year will become Rs. 110 at the end of the year. This 10% is the nominal interest rate, as we have not accounted for inflation.

Let us see the formula of the Current Account Balance (CAB) CAB = X - M + NI + NCT

X = Exports of goods and services M = Imports of goods and services NI = Net income abroad

[Salaries paid or received, credit / debit of income from FII & FDI etc. ]

NCT = Net current transfers people speak of the

Grants, Official, Assistance and

nominal interest rate, unless they

Pensions etc]

state otherwise.

REAL INTEREST RATE VS. NOMINAL INTEREST RATE Assume that inflation rate is 6% for the year and your fixed deposit earns 10% nominal interest rate.

After factoring in inflation, your deposit will earn a real interest rate of 4%.

REAL INTEREST RATE VS. NOMINAL INTEREST RATE

COMPARING REAL & NOMINAL INTEREST RATE

Nominal Interest Rate = 10%

Inflation = 6% Real Interest Rate = 4%

Let us see the formula of the Current Account Balance (CAB) CAB = X - M + NI + NCT

X = Exports of goods and services M = Imports of goods and services NI = Net income abroad

[Salaries paid or received, credit / debit of income from FII & FDI etc. ]

The relationship between nominal NCT = Net current transfers

Grants, Official, Assistance and

Fisher Equation:

Pensions etc]

Real Interest Rate = Nominal Interest Rate – Inflation

REAL INTEREST RATE VS. NOMINAL INTEREST RATE If inflation is positive , then the real interest rate is lower than the nominal interest rate.

If we have deflation and the inflation rate is negative , then the real interest rate will be larger.

Let us see the formula of the Current Account Balance (CAB) CAB = X - M + NI + NCT

X = Exports of goods and services M = Imports of goods and services NI = Net income abroad

[Salaries paid or received, credit / debit of income from FII & FDI etc. ]

NCT = Net current transfers

[ Workers' Remittances Grants, Official, Assistance and

and

Pensions etc]

Nominal Interest Rate.

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