The interest rate that is not adjusted for inflation is known as the nominal interest rate. The concept of nominal interest rate is just opposite to the concept of real interest rate. In other way, nominal interest rate can also be defined as the interest rate that is not adjustment for the full compounding effect. The interest rate, for which the compounding is not same as the basic time unit, is called nominal interest rate. However, if the inflation effect is not considered while calculating the interest rate, it results in a less realistic value.
A comparative study of nominal interest rate and real interest rate states that the nominal interest rate includes compensation for the lost value of the lender due to inflation while the real interest rate technically excludes inflation. The real interest rate actually gives the cost of borrowed money after the expected inflation hits the value of money.
The mathematical formulation, which represents the relationship between real and nominal interest rates, is as follows:
(1 + r)(1 + i) = (1 + R)
r stands for the real interest rate
i stands for the inflation rate
R stands for the nominal interest rate
Theoretically the relation between real interest rate and nominal interest rate is defined as follows:
Real interest rate = nominal interest rate – expected inflation
According to this analysis, the nominal rate here is the stated rate while the real interest rate is the interest rate that comes out after inflation, which results in losses to the value of fund. Since the future inflation can never be estimated, the premium paid for real interest rate may vary. On the other hand, the nominal interest rate is always known in advance, as the inflation is not deducted from it.
The nominal interest rate is obtained by multiplying the periodic interest rate by the number of periods per year. This can be explained with an example. A nominal annual interest rate of 12% that is based on the monthly compounding actually means a 1% interest rate per month. The value of nominal interest rate, when the compounding period is less than a year, is always greater than the equivalent rate with annual compounding.
Last Updated on : 1st July 2013