Real Interest Rate

You likely hear the interest rate and inflation rate discussed all the time. But how are the two linked?

We cover that in this video on the real interest rate.

First off, it’s important to note that the real interest rate is the nominal interest rate minus inflation.

Ok, but what’s the nominal interest rate?

When you go to a bank to get a loan, they charge you an interest rate. For simplicity, let’s say you’ve gotten a small loan of $100 and the bank is charging you an interest rate of 10%. If you pay back the loan over a year, the bank will end up with $110 – $10 more than they loaned you.

Now, what we commonly call an “interest rate” is really the nominal interest rate. So that 10% is not taking inflation into account. If inflation for the year ends up being 10%, the bank doesn’t actually make a real return because of the decrease in the value of money.

Can you calculate the real interest rate on that $100 loan? Yep, it’s 0%.

In the video, we’ll cover the more complicated scenario of what happened in the U.S. in the 1970s when inflation was much higher than expected.