What is the difference between Nominal Interest Rate and Real Interest Rate?

In Economics, the difference between real and nominal is the inflation element. There is the real GDP and the nominal GDP, Real wage rate and the nominal wage rate. Similarly, there is real interest rate and nominal interest rate.

Real interest rate and nominal interest rate

Nominal interest rate is the interest rate that is usually charged / paid by a bank. It is often referred as the market interest rate as it is the prevailing interest rate in the economy (usually charged by banks and other institutions). This nominal interest rate may be 8%, 10% or 12%, depending upon the bank or type of loans or deposits.

The real interest rate is the interest rate adjusted for inflation. It shows what the real return is for us from the deposit we have made in the bank; compared to the price level changes.

Take an example. We have made Rs 100 deposit in a bank last year and withdrawn it this year. If the interest rate (also called the nominal interest rate) is 8 %, we will get Rs 108 in total.

On the other hand, the inflation rate in the economy is 10%. This means that Rs 100 last year will be equal to Rs 110 this year to make the purchasing power of rupee constant.

Now we got just Rs 108 from our bank deposit but we need Rs 110 to make the value of our past Rs 100 intact.

In effect, we lost Rs 2 in our savings. Actually our real rate of interest was negative.

Real rate of interest = Nominal rate of interest – inflation.

In the previous example,

-2 = 8 – 10

The earning from our savings was negative because inflation rate was higher than the nominal interest rate.

Higher the inflation rate, lower will be the real interest rate.

Real interest rate considers inflation, whereas nominal interest rate doesn’t consider that.