What Is The Main Difference Between The Real And Nominal Rates Of Interest?

The real rate of interest is the growth in the power of the consumer to consumer over the entire life of a loan.

As for the nominal rate of interest, it is the number of monetary units paid per unit borrowed.  It is the overt and observable market rate of interest, which holds the ultimate point of consideration for financial institutions and the public equally.

In the absence of inflation, the real and the nominal rates of interest are the same.  However when the menace of inflation exists in a society, its presence causes a number of things to change, which includes the nominal rate of interest.   In the presence of inflation, it is imperative that the nominal rate of interest exceeds the real rate of interest.  The simple logic behind this theory is that the lenders demand a deserving increase in premium from the borrowers (which is definitely above the real rate) to compensate for the expected loss in the purchasing power of the principal amount that they have lent as well as the interest amount.

Interest is measured in dollar terms, not in terms of houses or cars or goods in general, the nominal interest rate measures the yield in dollars per year per dollar invested. But dollars can become distorted yardstick. The prices of houses, cares, and goods in general change from year to year, these days prices generally rise due to inflation.

Clearly we need another concept of interest that measures the return on investments in terms of real goods and services rather than the return in terms dollar. This alternative concept is the real interest rate, which measures the quantity of goods we get tomorrow for goods forgone today. The real interest rate obtained by correcting nominal interest rates for the rate of inflation.

The nominal interest rate is the interest rate on money in terms of money. When you read about interest rates in the newspaper, you are looking at nominal interest rates; they give the dollar return per dollar of investment.

In contrast, the real interest is corrected for inflation and is calculated as the nominal interest rate minus the rate of inflation.