BankingLesson 2 of 3

Nominal vs. real interest rates

Formulas

Real interest rate

Real Rate≈Nominal Rate−Inflation Rate

Strips inflation from the quoted rate to show real purchasing-power gain.

Future value (compound interest)

FV=PV×(1+r)^t

FV: Future value
PV: Present value
r: Interest rate per period
t: Number of periods

Present value

PV=FV÷(1+r)^t

Discount a future cash flow back to today's value.

Part 1 of 1

Nominal vs Real Interest Rate

The nominal interest rate is the rate as quoted — the number advertised by a bank or printed on a bond. It includes the effect of inflation.

The real interest rate strips inflation out to show the actual growth in purchasing power:

Real rate ≈ Nominal rate − Inflation rate

(The exact Fisher equation is: (1 + real) = (1 + nominal) ÷ (1 + inflation), but the approximation holds well when rates are low.)

Why it matters: if you earn 6% on a savings account but inflation is 4%, your purchasing power grows by only 2% — the real rate. You can buy more things with your money, but only 2% more, not 6% more.

The Fisher effect says that when expected inflation rises, rational lenders demand a higher nominal rate to protect their real return. As a result, nominal rates tend to track inflation expectations, while real rates remain comparatively stable over time.

Worked example

1A government bond offers 5% nominal yield.
2If expected inflation is 1.5%, the real yield ≈ 3.5% — a modest positive real return.
3If inflation unexpectedly surges to 6%, the real yield becomes −1% — the bondholder's purchasing power is shrinking despite receiving interest payments.

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