Nominal Interest Rate
What is Nominal Interest Rate?
The nominal interest rate is the stated interest rate on a loan or investment, before any adjustment for inflation.
It is the rate banks advertise and borrowers pay before accounting for price level changes. Nominal rates include expectations of future inflation and are influenced by monetary policy. They do not reflect the true return on investment in terms of purchasing power.
Nominal Interest Rate: a worked example
A central bank holds the money supply fixed at 700 billion dollars. Money demand is Qd = 900 - 25i, where i is the nominal interest rate in percent and quantities are in billions. Equilibrium sets 700 = 900 - 25i, so 25i = 200 and i = 8 percent. That 8 percent is the nominal rate, the number a bank would post at its loan window. An open market purchase now raises the money supply to 800 billion dollars: 800 = 900 - 25i gives 25i = 100 and i = 4 percent. If borrowers and lenders expect 3 percent inflation, the real rate implied by the new nominal rate is 4 - 3 = 1 percent. The posted number fell by 4 percentage points, and the purchasing power cost of borrowing fell with it.
The mistake students make with nominal interest rate
Comparing two economies by their posted rates and declaring the higher one more expensive to borrow in. Country A quotes 12 percent with 10 percent expected inflation, so its real rate is 2 percent. Country B quotes 5 percent with 1 percent expected inflation, so its real rate is 4 percent. Borrowing in B costs twice as much in purchasing power terms despite the smaller headline number. The nominal rate is the price of credit measured in dollars, and dollars are shrinking at different speeds in each place. Convert to real rates before ranking anything.
Nominal Interest Rate questions
Is the interest rate a bank advertises nominal or real?
Banks advertise nominal rates. The number on a car loan, a credit card statement, or a savings account is the stated percentage before any adjustment for inflation, and it determines the actual dollars paid or received. A 6 percent car loan on 10,000 dollars costs 600 dollars in interest for the year regardless of what inflation does. Working out the real rate is the borrower's job, done by subtracting expected inflation from the advertised figure.
Which interest rate belongs on the money market graph?
The nominal interest rate goes on the vertical axis of the money market. Holding wealth as cash means giving up the nominal return available on bonds, so the nominal rate is the opportunity cost that drives money demand. The loanable funds market uses the real interest rate instead, because savers and investors are comparing purchasing power across time. Mislabeling these two axes is one of the most frequently penalized errors on macroeconomics free response questions.
What makes nominal interest rates rise?
Nominal rates rise for several reasons worth keeping separate. A tighter money supply, from the central bank selling bonds or raising the reserve requirement, pushes the money supply curve left and lifts the nominal rate directly. Rising expected inflation lifts it too, because lenders add the inflation they anticipate onto the real return they require. Stronger loan demand from firms and governments also bids rates up. The first cause moves the real rate as well, while the second mostly does not.
This is the live Loanable Funds sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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