Pretend that you’re a money lender. The nominal amount of interest you get on a loan you made to someone else is 5%. The rate of inflation during the year that you’ve made the loan is 3%. What is the real interest rate on your loan? Explain intuitively the difference between the nominal and real interest rate.
Real interest rate = Nominal interest rate - Inflation rate
= 5% - 3%
Thus, the real interest rate on your loan is 2%.
A real interest rate is adjusted to remove the effects of inflation, which reflects the real cost of funds to the borrower and real return to the lender.
On the other hand, a nominal interest rate refers to an interest rate that does not remove inflation.
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