Interest Rates Explained: Nominal vs Real, and Who Sets Them

An interest rate is the price of borrowing money, expressed as a percentage of the amount borrowed per year. If you borrow $1,000 at a 5% annual interest rate, you pay $50 in interest for the year; if you lend or save $1,000 at 5%, you earn that $50. From the lender's side it is the reward for parting with money now instead of later; from the borrower's side it is the cost of getting money sooner than you otherwise could. That is the whole idea in one sentence, but two distinctions turn this simple price into one of the most important numbers in the economy: the gap between nominal and real interest rates, and the question of who actually sets rates. This guide covers both, with a worked Fisher equation example.

What an interest rate really represents

Money today is worth more than the same money a year from now, for three reasons. You could invest it and earn a return, so there is an opportunity cost to waiting. Inflation may erode its purchasing power. And the borrower might not pay you back, so there is risk. The interest rate bundles all three into a single price. A higher rate compensates lenders more for waiting, for expected inflation, and for risk; a lower rate compensates them less.

This is why interest rates are everywhere in economics. They set the return on saving, the cost of a mortgage or a car loan, the hurdle a business investment must clear to be worth financing, and the yield on government bonds. When the rate moves, all of those adjust, which is exactly why central banks use it as their main lever.

Nominal vs real interest rates

The single most important distinction is between the nominal interest rate and the real interest rate.

The nominal interest rate is the rate stated on the loan or the savings account, the number the bank advertises. It is not adjusted for inflation.

The real interest rate is the nominal rate adjusted for inflation. It tells you the true change in purchasing power, how much more actual stuff you can buy after the loan is repaid.

The difference matters because inflation quietly eats into the value of the money you get back. Suppose you lend $1,000 at a 6% nominal rate and receive $1,060 in a year. If prices rose 4% over that year, your $1,060 buys only about 2% more than your original $1,000 did. Your real return is roughly 2%, not the 6% on paper. Inflation transferred value from you, the lender, to the borrower.

The Fisher equation, with a worked example

The relationship between the two rates is captured by the Fisher equation. The approximate version, which is the one used on the AP and IB exams, is:

Real interest rate ≈ Nominal interest rate − Inflation rate

Or rearranged: Nominal ≈ Real + Expected inflation.

Worked example. A savings account pays a 6% nominal interest rate. Inflation over the year is 4%. The real interest rate is:

Real rate ≈ 6% − 4% = 2%

Your money grew 6% in dollars but only 2% in what it can actually buy. Now flip it: if inflation had turned out to be 7% instead of 4%, your real rate would be 6% − 7% = −1%. A negative real rate means that even after earning interest, your purchasing power shrank. This is why savers hate high inflation and why lenders build expected inflation into the rates they charge.

The Fisher equation has an exact form too, which matters when rates are large:

(1 + nominal) = (1 + real) x (1 + inflation)

Using the numbers above: (1.06) = (1 + real)(1.04), so 1 + real = 1.06 / 1.04 = 1.0192, giving a real rate of 1.92%. The approximation (2%) is close enough for exam work at normal rates, but the exact version is more accurate when inflation is high. You can check either with the real interest rate calculator. For a deeper treatment of the underlying idea, see our guide on real vs nominal values.

One more subtlety worth knowing: the ex ante real rate uses expected inflation (what borrowers and lenders anticipate when they agree on a loan), while the ex post real rate uses actual realized inflation. When inflation surprises to the upside, the realized real rate ends up lower than either party expected, which is why unexpected inflation is what really redistributes wealth from lenders to borrowers.

Who sets interest rates

There is no single rate and no single setter. It is more accurate to say interest rates are set by a mix of central bank policy and market forces.

The central bank sets the policy rate. A country's central bank, such as the Federal Reserve in the United States, targets a very short-term rate, the federal funds rate, which is the rate banks charge each other for overnight loans. The central bank does not dictate this rate by decree; it hits its target mainly through open market operations, buying and selling government bonds to change the money supply. Buying bonds injects money and pushes rates down; selling bonds withdraws money and pushes rates up. Adjusting the rate paid on bank reserves and the discount rate are additional tools.

Markets set everything else. The policy rate is only the very short end. Longer-term rates on mortgages, corporate bonds, and government debt are set in markets by the supply of saving and the demand for borrowing, plus expectations about future policy, inflation, and risk. This is the loanable funds market: savers supply funds, borrowers demand them, and the interest rate moves to balance the two. A riskier borrower or a longer loan carries a higher rate on top of the policy rate.

So when the news says the central bank raised rates, it means the bank moved its short-term target. That change ripples outward: it raises the cost banks face, which they pass on to loans, which cools borrowing, spending, and eventually inflation. The mechanism is the heart of monetary policy.

How central banks move rates, and why

Central banks adjust rates to steer the economy between two dangers, high inflation and high unemployment.

To fight inflation, they raise rates (contractionary policy). Selling bonds shrinks the money supply and lifts the interest rate. Higher rates make borrowing costlier, so businesses invest less and households spend less on credit-financed purchases. Aggregate demand falls, and with it the upward pressure on prices.

To fight a recession, they cut rates (expansionary policy). Buying bonds expands the money supply and lowers the interest rate. Cheaper borrowing encourages investment and consumption, raising aggregate demand, output, and employment.

You can watch this play out visually. The interactive monetary policy sandbox lets you shift the money supply and see the equilibrium interest rate move, and the monetary policy module walks through the full transmission from the rate change to output and prices. Seeing the money market curve shift is far more memorable than reading about it.

Putting it together

An interest rate is the price of money over time. The nominal rate is what you are quoted; the real rate, found by subtracting inflation via the Fisher equation, is what you actually earn or pay in purchasing power. Central banks set the short-term policy rate to manage inflation and unemployment, and markets extend that into the full structure of rates across the economy. Master the nominal-versus-real distinction and the money market mechanism, and most of macroeconomic policy stops being mysterious. Practice the calculation with the real interest rate tool, reinforce the terms in the glossary, and drill the graph in the sandbox.