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.
