INFLATION AND REAL INTEREST RATES
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When we talk about interest rates, it is usually the nominal
interest rate that we are referring to: a mortgage with a 9 percent interest
rate, a car loan with an 8.5 percent rate, a bond that pays out 6 percent
annually. These are all instances of nominal interest rates.
interest rates are the rates of return after adjusting for inflation.
Real interest rates measure the rate of growth of your purchasing
power. Suppose that you invested $1,000 in a bond that pays out 6 percent
annually, but in the first year, inflation is measured at 2 percent. This means
that your rate of return in terms of purchasing power has increased only by
approximately 4 percent in year one. Let's look at the formula for calculating
real interest rates:
The fact that future inflation rates are uncertain makes your
future real interest rate returns risky. Even though an investment may guarantee
you a certain nominal rate, there is no guarantee it will purchase the goods and
services you expect. The best that you can do is to factor in a guess of future
inflation rates and plan accordingly.
Nominal rates are usually higher in years with high
inflation. This is because investors demand minimum real rates of return on
specific kinds of investments. In the next section, you will learn about a
factor that affects real and nominal interest rates. That factor is the supply