Question

Please explain the difference between the nominal and real interest rate in the short-run and the long-run. How and why does the quantity theory help us understand the relationship between the money supply, interest rates and inflation? How and why are nominal interest rates so low in the U.S. today? Please all the tools at your disposal to demonstrate your understanding of the market today.

Answer 1

Nominal interest rate is defined as the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate reflects the rate of time-preference for current goods over future goods.

Nominal interest rates exist in contrast to real interest rates and effective interest rates. Real interest rates tend to be important to investors and lenders, while effective rates are significant for borrowers as well as investors and lenders.

Nominal rate = real interest rate + inflation rate, Real rate = nominal rate - inflation rate.