4.2 Nominal vs. Real Interest Rates

Money makes it possible to ____ the value of goods and services, and interest rates provide a measure of the ____ of money that is borrowed or saved.

• compare, price/cost

• pay for, profit

• price/cost, compare

• reduce, inflation

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MEA-3

Define Nominal Interest Rate (flash card question)

• The rate of interest paid for a loan

• The real interest rate + expected inflation

• The face value interest rate - ex. you finance a car for 7% apr

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Define the real interest rate

• The real price of borrowing money, minus the rate of inflation

• The amount of profit banks make after they control for inflation on the nominal interest.

• Ex. A bank charges a 5% nominal interest rate. They expect 2% inflation, so the RIR is 3%.

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Lenders and borrowers establish nominal interest rates as the ____ of their expected real interest rate and expected inflation.

A real interest rate can be calculated in ____ by subtracting the actual inflation rate from the nominal interest rate.

What is the formula for the fisher effect?

• real interest rate = nominal interest rate - expected inflation

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