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♪ [music] ♪

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- [Narrator] What is [br]the real interest rate?

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Well, first let's start with [br]what the nominal interest rate is.

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That's the interest rate you see [br]on a bank or credit card statement.

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So when people say interest rate,

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they usually mean [br]nominal interest rate.

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To see the difference

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between nominal [br]and real interest rates,

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let's turn to an example.

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Suppose that a bank lends $100[br]at a nominal interest rate of 10%,

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but suppose also that over the year[br]the inflation rate is 10%.

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At the end of that year,[br]the borrower pays back the bank $110.

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That looks pretty good on paper,[br]but during the year,

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money has become less valuable.

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Due to inflation, what used [br]to cost $100 now costs $110.

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So what is the bank's real return?

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Zero.

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More generally, we can write[br]that the real interest rate

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is equal to the nominal rate,[br]the rate charged on paper,

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minus the inflation rate.

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Inflation reduces [br]the real return on a loan.

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So unexpected inflation [br]can redistribute wealth

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from the lender to the borrower,

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and that's exactly what happened[br]in the 1970s in the United States.

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Suppose, for example,

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that you had taken out [br]a home mortgage in the 1960s.

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As a borrower, [br]you'd have done really well

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because few people anticipated

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the high inflation rates [br]of the 1970s.

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So borrowers ended up paying off [br]their mortgages in dollars

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that were worth a lot less[br]than anyone had expected.

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As you can see, in order [br]to understand interest rates,

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understanding inflation is crucial.

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If you'd like to learn more[br]about inflation, click here.

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Or, if you'd like [br]to test your knowledge

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on the real interest rate,[br]click here.

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♪ [music] ♪

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