IB DP Economics - Unit 3 - Real versus nominal interest rates-Study Notes - New Syllabus

Real versus Nominal Interest Rates

Interest rates are important in determining:

• Saving
• Borrowing
• Investment
• Consumption

Economists distinguish between:

• Nominal interest rates
• Real interest rates

The difference between them is important because inflation affects the purchasing power of money.

Nominal Interest Rate

The nominal interest rate is the stated or observed interest rate before adjusting for inflation.

It is the rate charged on loans or paid on savings by financial institutions.

Examples of Nominal Interest Rates

• Bank loan interest rates
• Savings account interest rates
• Mortgage rates
• Bond interest rates

Limitation of Nominal Interest Rates

Nominal interest rates do not show the true increase in purchasing power because they ignore inflation.

If inflation is high, the actual gain from saving may be much lower.

Real Interest Rate

The real interest rate is the interest rate adjusted for inflation.

It measures the actual increase in purchasing power resulting from saving or lending.

Formula for Real Interest Rate

\( \mathrm{Real\ Interest\ Rate = Nominal\ Interest\ Rate – Inflation\ Rate} \)

This formula gives an approximate real interest rate.

Meaning of the Real Interest Rate

The real interest rate shows:

• The true return to savers
• The true cost of borrowing

Positive Real Interest Rates

If:

\( \mathrm{Nominal\ Interest\ Rate > Inflation\ Rate} \)

then the real interest rate is positive.

This means purchasing power increases over time.

Negative Real Interest Rates

If:

\( \mathrm{Inflation\ Rate > Nominal\ Interest\ Rate} \)

then the real interest rate becomes negative.

This means purchasing power decreases over time.

Example of a Negative Real Interest Rate

If a savings account pays:

\( \mathrm{4\%} \)

interest but inflation is:

\( \mathrm{6\%} \)

the saver loses purchasing power despite earning interest.

Importance of Real Interest Rates

Real interest rates influence:

• Saving decisions
• Borrowing decisions
• Investment decisions
• Consumer spending

Effect on Savers

Higher real interest rates encourage saving because returns are greater in real terms.

Lower or negative real interest rates discourage saving.

Effect on Borrowers

Lower real interest rates reduce the real cost of borrowing.

This may encourage:

• Consumer borrowing
• Business investment

Relationship with Monetary Policy

Central banks monitor both:

• Nominal interest rates
• Inflation rates

because real interest rates affect aggregate demand and economic activity.

Real Interest Rates During Inflation

If inflation rises rapidly while nominal interest rates remain unchanged:

• Real interest rates decrease.
• Borrowing may increase.
• Savings become less attractive.

Real Interest Rates During Deflation

If prices are falling (deflation):

• Real interest rates may become very high.
• Borrowing and spending may decrease.

Comparison Between Nominal and Real Interest Rates

Key Point:

• Nominal interest rates do not account for inflation.
• Real interest rates measure the actual change in purchasing power.
• Real interest rate is approximately equal to nominal interest rate minus inflation rate.
• Positive real interest rates encourage saving.
• Negative real interest rates reduce the real value of savings.