Nominal Interest Rate


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.


Loading the player...

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.

  1. Inflation

    The rate at which the general level of prices for goods and services ...
  2. Nominal Rate Of Return

    The amount of money generated by an investment before expenses ...
  3. Real Interest Rate

    An interest rate that has been adjusted to remove the effects ...
  4. Nominal Value

    The stated value of an issued security. Nominal value in economics ...
  5. Interest Rate Parity

    A theory in which the interest rate differential between two ...
  6. Nominal Yield

    The coupon rate on a bond. The nominal yield is the interest ...
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

    These Will Be the World's Top Economies in 2020

    Discover the current economic forces that are anticipated to significantly shift the landscape of the world's most powerful economies over the next decade.
  10. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  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. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  5. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  6. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  4. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  5. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  6. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
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!