interest rate is the difference between the nominal interest rate
and the rate of inflation.
If lenders and borrowers are concerned with the real costs
measured in terms of purchasing power, the nominal interest
rate will be set at the real rate they require plus an amount to
cover any expected rate of inflation. Consider a one-year loan
that is meant to earn a real return to the lender of 3 percent. If
the expected rate of inflation is zero, the nominal interest rate
for the loan will also be 3 percent. If, however, a 10 percent
inflation is expected, the nominal interest rate will have to be
set at 13 percent in order for the real return to be 3 percent.
This point is often overlooked, and as a result people are
surprised at the high nominal interest rates that exist during
periods of high inflation. But it is the real interest rate that
matters more to borrowers and lenders. For example, as the
accompanying figure shows, in 1981 the nominal interest rate
on three-month Treasury bills was almost 18 percent, but the
high inflation rate at the time meant that the real interest rate
was just over 5 percent. In contrast, a decade later in 1990,
nominal rates had fallen to just below 13 percent but inflation
had fallen further so that the real interest rate had actually
increased to almost 8 percent. Thus, the period of lower
nominal interest rates was actually a period of higher real
interest rates.
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