Nominal Interest Rate

AAA

DEFINITION of 'Nominal Interest Rate'

The interest rate before taking inflation into account. The nominal interest rate is the rate quoted in loan and deposit agreements. The equation that links nominal and real interest rates is:
(1 + nominal rate) = (1 + real interest rate) (1 + inflation rate).
It can be approximated as nominal rate = real interest rate + inflation rate.

INVESTOPEDIA EXPLAINS 'Nominal Interest Rate'

To avoid purchasing power erosion through inflation, investors consider the real interest rate, rather than the nominal rate. One way to estimate the real rate of return in the U.S. is to observe the interest rates on Treasury Inflation-Protected Securities (TIPS). The difference between the yield on a Treasury bond and the yield on TIPS of the same maturity provides an estimate of inflation expectations in the economy.

For example, if the nominal interest rate offered on a three-year deposit is 4% and the inflation rate over this period is 3%, the investor’s real rate of return would be 1%. While the real rate is low, at least it will preserve the investor’s purchasing power. On the other hand, if the nominal interest rate is, say, 2% in an environment of 3% inflation, the investor’s purchasing power would erode by 1% per annum.

Central banks set short-term nominal interest rates, which then form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels after a major recession to stimulate economic activity through low real interest rates. A necessary condition for such stimulus measures is that inflation should not be a present or near-term threat. Conversely, during inflationary times, central banks may overestimate the inflation level and keep nominal interest rates too high. The resulting elevated level of real interest rates may have serious economic repercussions.

VIDEO

Loading the player...
RELATED TERMS
  1. Nominal Rate Of Return

    The amount of money generated by an investment before expenses ...
  2. Fisher Effect

    An economic theory proposed by economist Irving Fisher that describes ...
  3. Inflation

    The rate at which the general level of prices for goods and services ...
  4. Nominal Value

    The stated value of an issued security. Nominal value in economics ...
  5. Nominal Yield

    The coupon rate on a bond. The nominal yield is the interest ...
  6. Interest Rate Parity

    A theory in which the interest rate differential between two ...
RELATED FAQS
  1. How does the Fisher effect illustrate returns on bonds?

    The Fisher effect illustrates the relationship between inflation, real interest rates and nominal interest rates by showing ... Read Full Answer >>
  2. What is the difference between real and nominal interest rates?

    A nominal interest rate is the interest rate that does not take inflation into account. It is the interest rate that is quoted ... Read Full Answer >>
  3. What is the relationship between inflation and interest rates?

    Inflation and interest rates are linked, and frequently referenced in macroeconomics. Inflation refers to the rate at which ... Read Full Answer >>
  4. In what manner will a recession likely affect the marginal-propensity-to-save rate ...

    The marginal propensity to save, or MPS, rises in most, though not all, recessions. This makes perfect sense on an individual ... Read Full Answer >>
  5. What are key economic growth rates that can be used to determine the economic health ...

    Before you can determine the proper indicators for economic health, you must understand what causes an economy to grow and ... Read Full Answer >>
  6. Why would a country's gross domestic product (GDP) and gross national income (GNI) ...

    A country’s gross domestic product, or GDP, and gross national income, or GNI, are likely to differ considerably because ... Read Full Answer >>
Related Articles
  1. Investing Basics

    How Banks Set Interest Rates On Your Loans

    On the face of it, figuring out how a bank makes money is a pretty straightforward affair. A bank earns a spread on the money it lends out from the money it takes in as a deposit. The net interest ...
  2. Economics

    The International Fisher Effect: An Introduction

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  3. Economics

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  4. Bonds & Fixed Income

    Understanding Interest Rates, Inflation And The Bond Market

    Get to know the relationships that determine a bond's price and its payout.
  5. Active Trading

    Shield Your Portfolio From Inflation For Real Returns

    Inflation-protected securities are part of the equation, but they're not a perfect solution.
  6. Forex Education

    Why Interest Rates Matter For Forex Traders

    Central banks' rate changes are one of the biggest influences on the forex market.
  7. Economics

    The Importance Of Inflation And GDP

    Learn the underlying theories behind these concepts and what they can mean for your portfolio.
  8. Investing Basics

    How To Prepare For Rising Interest Rates

    Get to know the basic, time-tested strategies that any investor or trader can use to profit in a rising interest rate environment.
  9. Economics

    Is Texas The Future Of America?

    The top three fastest-growing cities are located in Texas and 20% of jobs created between 2009 and 2014 were in the Lone Star State.
  10. Markets

    Rising Interest Rates: Who it Helps, Who it Hurts

    When interest rates rise, the impact hits some of us differently. Here's why.

You May Also Like

Hot Definitions
  1. National Currency

    The currency or legal tender issued by a nation's central bank or monetary authority. The national currency of a nation is ...
  2. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  3. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  4. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  5. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  6. Current Account Deficit

    A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!