Nominal Interest Rate

Nominal Interest Rate: How to Calculate, Effects & Examples

nominal interest rate definition

What is a Nominal Interest Rate?

The nominal interest rate, often referred to simply as the interest rate, is the stated or named interest rate that a financial instrument or financial transaction carries before taking into account inflation. It is typically expressed as an annual percentage rate (APR).

The nominal interest rate does not account for the compounding period (if interest is compounded more than once in a year) or inflation. Because of this, the nominal rate might not accurately represent the real cost of borrowing or the real yield of an investment over time.

For example, if a loan has a nominal rate of 5% per year, then that’s the rate at which interest will accrue on the loan’s balance. However, this does not consider the effect of inflation, which might erode the purchasing power of the money that the lender receives back.

In contrast, the real interest rate adjusts the nominal rate for inflation, reflecting the rate of return in terms of real purchasing power. Similarly, the effective interest rate adjusts the nominal rate for the compounding period, reflecting the true rate of return when interest is compounded more than once per year.

Key Points
  1. Nominal interest rates are the stated rates on financial instruments or loans before considering inflation.
  2. They do not account for changes in purchasing power due to inflation.
  3. Nominal interest rates are determined by factors such as central bank policies, market conditions, borrower risk, and inflation expectations.

Understanding Nominal Interest Rates

The nominal interest rate is a pivotal concept in finance and economics, serving as the basis for many calculations and decisions. Understanding its role and how it relates to other forms of interest is essential for making informed financial decisions.

  1. Explanation of How it Works The nominal interest rate, sometimes referred to as the annual percentage rate (APR), represents the rate of interest before taking inflation into account. It is the stated or “named” rate on a loan or investment, indicating the amount of interest the borrower will pay or the investor will receive in a year, excluding compounding.

    For borrowers, the nominal rate denotes the cost of the loan. For lenders or investors, it signifies the return on an investment. However, it does not consider the effects of compounding. If compounding occurs more than once a year, the effective interest rate will be higher than the nominal rate.
  2. Difference between Nominal and Real Interest Rate While the nominal interest rate is the rate as stated in the loan agreement or investment, the real interest rate adjusts the nominal rate to take inflation into account. The real interest rate is what the nominal rate would be once the effects of inflation are removed.
  3. Inflation erodes the purchasing power of money over time. Therefore, the real interest rate more accurately reflects the true cost of borrowing or the real return on an investment in terms of its impact on purchasing power.

    In essence, the nominal interest rate tells you how much your money will grow in numerical terms, while the real interest rate tells you how much your purchasing power will increase or decrease. Understanding both these rates helps paint a comprehensive picture of the financial market conditions and the true value of money over time.

    Factors Influencing Nominal Interest Rate

    Various factors can influence the nominal rate, from macroeconomic conditions to monetary policy decisions and market demand for credit. Here, we will delve into some of these influences.

    1. Monetary Policy

    Central banks, such as the Federal Reserve in the U.S. or the European Central Bank in the Eurozone, often use interest rates as a tool to control money supply and manage economic stability. By manipulating short-term interest rates, central banks can influence the overall level of nominal interest rates in the economy. For instance, to stimulate economic activity during a slowdown, central banks might lower interest rates, making borrowing cheaper and encouraging spending.

    2. Inflation Expectations

    Expectations about future inflation can influence nominal rates. If inflation is expected to rise, lenders will demand higher interest rates to compensate for the anticipated loss in purchasing power of the money they lend. This additional compensation is known as an inflation premium, which is added to the real interest rate to arrive at the nominal rate.

    3. Economic Conditions

    Broader economic conditions and perceptions of risk also affect nominal interest rates. During periods of economic uncertainty or recession, investors might flock to safer investments like government bonds, driving up their prices and pushing down their yields (which move inversely to prices). This can result in lower nominal rates. Conversely, in strong economies where confidence is high, nominal rates can increase as more individuals and businesses are willing to borrow and invest.

    Calculating Nominal Interest Rate

    Calculating the nominal interest rate is straightforward when you have access to the required information. Below, we will discuss the formula, calculation steps, and an example to make this process clear.

    1. Formula and Calculation Steps The nominal interest rate is usually given directly in the terms of a loan or an investment, often expressed as an annual percentage. It’s the stated rate before considering inflation or compounding.

      However, in instances where it’s not directly provided but the real interest rate and inflation rate are known, the nominal interest rate can be calculated using the Fisher equation:

      Nominal interest rate = Real interest rate + Inflation rate + (Real interest rate * Inflation rate)

      This formula is derived from the approximation that the nominal rate is approximately the sum of the real interest rate and the inflation rate. However, to more accurately account for the impact of inflation on the real rate, an additional term (Real interest rate * Inflation rate) is included.
    2. Example of Nominal Interest Rate Calculation For example, if you know the real interest rate is 2% and the inflation rate is 1.5%, you can calculate the nominal interest rate as follows:

      Nominal interest rate = 2% + 1.5% + (2% * 1.5%)
      = 3.53%

      So, the nominal rate in this instance is 3.53%.

    Understanding the calculation of the nominal interest rate can assist in financial planning and investment decision-making, providing clarity about the stated cost of borrowing or the return on an investment.

    Effects of Nominal Interest Rate

    The nominal interest rate has far-reaching effects on the economy, influencing individual and corporate financial decisions as well as broader economic dynamics.

    1. Impact on Loans and Savings Nominal interest rates directly affect the cost of loans and the return on savings. Higher nominal rates make borrowing more expensive, potentially discouraging individuals and businesses from taking out loans for consumption or investment. Conversely, higher rates increase the return on savings, incentivizing individuals to save more. The opposite is true when nominal rates are low.
    2. Influence on Investments The level of nominal interest rates can also impact investment decisions. When nominal rates are high, risk-free investments like government bonds become more attractive, potentially drawing funds away from riskier investments like stocks. When nominal rates are low, investors may be encouraged to invest in riskier assets that offer higher potential returns.
    3. Effect on Economic Activity and Inflation On a macroeconomic scale, nominal interest rates can influence overall economic activity and inflation. Lower nominal rates can stimulate economic growth by reducing borrowing costs and encouraging consumer spending and business investment. However, this could potentially lead to higher inflation. Conversely, high nominal rates could slow economic growth and curb inflation by increasing borrowing costs and discouraging spending and investment.
    4. Nominal Interest Rates in Monetary Policy

      Nominal interest rates play a pivotal role in the formation and implementation of monetary policy by central banks. They serve as a key tool for managing the economy, influencing borrowing costs, and thus, aggregate demand. This section explores the role of nominal rates in central banks’ policy decisions and their use in setting policy targets.

      1. Role in Central Banks’ Policy Decisions Central banks, like the Federal Reserve in the U.S. or the European Central Bank in the Eurozone, use interest rates as a primary tool to control inflation and stabilize the economy. By adjusting the short-term interest rate (often referred to as the ‘policy’ or ‘benchmark’ rate), they can influence the broader range of nominal interest rates in the economy.

        For instance, during economic downturns, central banks often reduce policy rates to stimulate economic activity. Lower nominal rates decrease the cost of borrowing, encouraging businesses and consumers to spend and invest more. Conversely, during periods of high inflation or overheating economies, central banks might increase policy rates, raising borrowing costs to cool down the economy and control inflation.
      2. Use of Nominal Interest Rates in Setting Policy TargetsCentral banks also set specific targets for nominal interest rates to guide their monetary policy actions. For example, in an inflation-targeting regime, the central bank might adjust the policy rate with an aim to steer nominal rates in a direction that would help achieve its inflation target.

      In summary, nominal interest rates serve as a critical tool for central banks in executing monetary policy. Their manipulation can have significant implications for economic activity, inflation, and the broader financial environment. Understanding their role in monetary policy can help in interpreting central bank actions and their likely impact on the economy.

      Examples of Nominal Interest Rates

      To solidify our understanding of nominal interest rates, let’s look at a few examples. These examples are not only meant to illustrate the calculation and application of nominal rates, but also to show how they can vary across different scenarios and economic environments.

      1. Example in a Loan

      Consider a loan where the lender quotes a nominal interest rate of 6% per annum. This rate implies that for every $100 borrowed, the borrower will owe $6 in interest over one year. However, this calculation does not take into account the impact of inflation. So, the actual cost of the loan (in terms of purchasing power) may be less if there is positive inflation.

      2. Example in Savings

      Suppose you deposit $1000 in a savings account that offers a nominal interest rate of 2% per annum. After a year, your savings would grow to $1020. However, this does not consider the effect of inflation. If the inflation rate was 1.5% over the year, your real return (in terms of purchasing power) would be less than 2%.

      3. Central Bank Policy Rate Example

      Central banks commonly adjust nominal interest rates to influence economic activity. For example, following the 2008 financial crisis, the U.S. Federal Reserve lowered its policy rate to near zero. This action resulted in lower nominal rates throughout the economy, making borrowing cheaper in an effort to stimulate economic activity during the recession.

      4. International Comparison Example

      Nominal rates can vary significantly across countries, reflecting differences in monetary policy, inflation expectations, and economic conditions. For instance, as of 2021, the nominal rate set by the U.S. Federal Reserve was near zero, reflecting efforts to stimulate the economy amidst the COVID-19 pandemic. In contrast, some emerging economies had much higher nominal rates, reflecting higher inflation expectations and different economic conditions.

      FAQs

      What is a nominal interest rate?

      A nominal interest rate is the stated interest rate on a financial instrument or loan before accounting for inflation.

      How is the nominal interest rate different from the real interest rate?

      The nominal interest rate does not consider inflation, while the real interest rate adjusts for inflation and reflects the actual purchasing power of money.

      How is the nominal interest rate determined?

      The nominal interest rate is determined by various factors, including central bank policies, market demand and supply for loans, inflation expectations, and the risk associated with the borrower.

      Can the nominal interest rate be negative?

      Yes, in certain economic conditions, nominal interest rates can be negative, indicating that lenders are effectively paying borrowers to borrow money.


      About Paul

      Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.


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