nominal interest rate

This is one of the greatest misnomers in economics. If real interest rate is the real rate of interest, the nominal interest rate is not the real thing. In fact it is the sum of the expected real interest rate plus the expected inflation rate over the duration of the loan. Its adding apples and pears. Nominal interest rate is not an interest rate at all, but the sum of two diferent concepts in economics.

Adding Two Uncertainties

The sum of these two uncertain estimates does not give a secure and trustworthy interest rate as most people have come to trust. It is definetely not a deterministic quantity for the investor to make rational decisions by. The investor ends up not knowing what the real interest rate of investment will be, as opposed to securities that deliberaty guarantee a real rate like today's TIPS (Treasury Inflation Protected Securities). Many other countries do not make this mistake, preferring to call a spade a spade. However, one should be cautious to state exactly what they mean in countries with fewer protections for borrowers given fraudulent information, for example Chile or Brasil. When comparing interest rates, nominal interest rates and effective interest rates have to be distinguished. An interest rate is called nominal if the period of time after that the interest is credited (e.g. a month) is not identical to the basic time unit (normally a year).

Example

Let's assume an annual interest rate of 6% which is credited after each month. This means that an interest of 6%/12 = 0.5% is credited every month. After one year, the initial capital is increased by the factor (1+0.005)¹² ≈ 1.0616. As a result, this nominal interest rate is equivalent to an effective interest rate of 6.16%.

Nominal Interest Rate

Adding Two Uncertainties

Example

See also