inflation is 5 percent. When the price level is falling, inflation is
negative. If prices are falling at a rate of 2 percent per year, the
rate of inflation is –2 percent.
Real and Nominal Interest Rates
In the presence of inflation, we need to distinguish between the
real interest rate and the nominal interest rate. The nominal
interest rate is measured simply in dollars paid. If you pay me
$7 interest for a $100 loan for one year, the nominal interest
rate is 7 percent.
Consider further my one-year loan to you of $100 at the
nominal rate of 7 percent. The real rate that I earn depends on
what happens to the price level during the course of the year. If
the price level remains constant over the year, then the real
rate that I earn is also 7 percent—because I can buy 7 percent
more goods and services with the $107 that you repay me than
with the $100 that I lent you. However, if the price level were to
rise by 7 percent during the year, the real rate would be zero
because the $107 you repay me will buy exactly the same
quantity of goods as did the $100 I gave up. If I were unlucky
enough to have lent money at a nominal rate of 7 percent in a
year in which prices rose by 10 percent, the real rate would be –
3 percent. The real rate of interest concerns the ratio of the
purchasing power of the money repaid to the purchasing
power of the money initially borrowed, and it will be different
from the nominal rate whenever inflation is not zero. The real