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There is a relationship between the nominal interest rate, the real interest rate, and the rate of inflation. The real interest rate is equal to the nominal interest rate minus the inflation rate; the real interest rate, or the purchasing power of the loan, is equal to the interest earned less the effect of inflation. In the problem above, the nominal interest rate was 5%, the inflation rate was 5%, and thus, using the equation, the real interest rate was 0%. In this case, the lender received no protection from default or payment for the inconvenience of having the money unavailable. In general, lenders always charge a nominal interest rate greater than the expected inflation rate.

Fischer Effect

The nominal interest rate is what is paid on the balance due on a loan. If the equation presented above is rearranged, we see that the nominal interest rate is equal to the real interest rate plus the inflation rate. In the previous section on the quantity theory of money, we learned that when the Fed increases the money supply, the major effect is an increase in the inflation rate.

From the equation just presented, we learn a second effect of an increase in the money supply. Because the nominal interest rate is equal to the real interest rate plus the inflation rate, an increase in the inflation rate due to an increase in the money supply by the Fed results in an increase in the nominal interest rate. This increase is affected by lenders to ensure that they receive the real interest rate they wanted on the loan, regardless of the effects of inflation. The point for point adjustment of the nominal interest rate to the real interest rate is called the Fischer effect.

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