4.2 Nominal v. Real Interest Rates
The real interest rate is the nominal rate minus expected inflation (Fisher equation) — it measures gained purchasing power, not just dollars.
The nominal interest rate is the stated rate on a loan or deposit; the real interest rate adjusts it for inflation. The Fisher equation ties them together: real rate ≈ nominal rate − expected inflation, or equivalently nominal rate ≈ real rate + expected inflation.
Distinguish expected from actual inflation. Borrowers and lenders agree to a nominal rate based on EXPECTED inflation; the realized real rate depends on ACTUAL inflation. When inflation comes in higher than expected, borrowers win — they repay in cheaper dollars — and lenders lose. Lower-than-expected inflation reverses the transfer.
Watch the graph link too: the loanable funds market (Topic 4.7) is drawn with the REAL interest rate, while the money market (Topic 4.5) uses the NOMINAL rate. Many multiple-choice points come from just knowing which rate belongs where.
Key terms for 4.2
Practice the math
Flipping the Fisher equation — the real rate is nominal MINUS expected inflation. If a bank charges 6% and expected inflation is 4%, the lender's expected real return is only 2%.
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