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