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- [Narrator] What is the real interest rate?
Well, first let's start with what the nominal interest rate is.
That's the interest rate you see on a bank or credit card statement.
So when people say interest rate,
they usually mean nominal interest rate.
To see the difference
between nominal and real interest rates,
let's turn to an example.
Suppose that a bank lends $100 at a nominal interest rate of 10%,
but suppose also that over the year the inflation rate is 10%.
At the end of that year, the borrower pays back the bank $110.
That looks pretty good on paper, but during the year,
money has become less valuable.
Due to inflation, what used to cost $100 now costs $110.
So what is the bank's real return?
Zero.
More generally, we can write that the real interest rate
is equal to the nominal rate, the rate charged on paper,
minus the inflation rate.
Inflation reduces the real return on a loan.
So unexpected inflation can redistribute wealth
from the lender to the borrower,
and that's exactly what happened in the 1970s in the United States.
Suppose, for example,
that you had taken out a home mortgage in the 1960s.
As a borrower, you'd have done really well
because few people anticipated
the high inflation rates of the 1970s.
So borrowers ended up paying off their mortgages in dollars
that were worth a lot less than anyone had expected.
As you can see, in order to understand interest rates,
understanding inflation is crucial.
If you'd like to learn more about inflation, click here.
Or, if you'd like to test your knowledge
on the real interest rate, click here.
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