For example, when you borrow $1,000, and you are charged 4% for your borrowing in an economy where the inflation rate is 1.5%, you effectively pay 2.5% (4%-1.5%) for the borrowing. When you deposit your funds and receive 3% interest in the same economy, you are effectively earning only 1.5% (3%-1.5%) on your deposit, the rest of the value (1.5%) being lost due to inflation.

When your nominal rate equals the rate of inflation for deposits, your real interest rate is zero, and your money does not earn anything for you. In nominal terms, you may have more money, but they will have the same purchasing power, which makes it equal in the real terms.

For example, you deposit $1,000 for a year at an interest rate of 1.5% in the economy where inflation is 1.5%. After a year you have $1,015, which is invested $1,000 plus $15 interest (1,000*1.5%). In nominal terms, you have $15 more, but in real terms, because the prices have increased by the inflation rate which is 1.5% you still can afford the same amount of goods and services with $1,015 as you could a year ago with $1,000.

Login

Accessing this course requires a login. Please enter your credentials below!