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  Monday November 20, 2017

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INFLATION AND REAL INTEREST RATES
Learn even more about this topic with the Encyclopedia of Personal Finance™

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.

Real 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 of money.




LEARN EVEN MORE WITH THE ENCYCLOPEDIA OF PERSONAL FINANCE. CLICK HERE!

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