Real Interest Rates

Let’s say you lent your friend $5 to buy 20 gum-balls for 25¢ each. You agree that he will pay you $10 in one year’s time.

That means that in the future (with prices held constant), you'd be able to purchase 40 gum-balls with your $10, 20 more than you would've if you purchased now!

However, what would happen if the price increased to 33¢ per gum-ball? You would not actually be 20 gum-balls better off by making the loan, but rather only 10 gum-balls better off when you account for the price increase.

This simple example represents nominal vs. real interest rates!

Nominal interest rates (i) explained

Nominal interest rates are exactly what you would expect; they are just “normal” interest rates.

Nominal interest rates are the pure percentage gain of dollars after a certain period of time.

In our gum-ball situation, nominal interest was represented when we didn't consider inflation:

"That means that in the future (with prices held constant), you'd be able to purchase 40 gum-balls with your $10, 20 more than you would've if you purchased now!"

However, in economics you often won't be dealing with gum-balls for calculating nominal interest rates. We'll often work with loans.

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