Nominal Interest Rate

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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.

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BREAKING DOWN '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.

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