Adjusting Interest for Inflation

We have just explained why investment depends on the rate of interest. But we haven't yet allowed for inflation. So far, in this text, pretty nearly everything has been "adjusted for inflation." Interest, too, must be adjusted for inflation. Following the pattern, the adjusted interest rate is called "real interest." To be correct, we should say that investment depends on "real interest."

"NOMINAL" INTEREST

The nominal rate of interest is the rate written on the bond or mortgage. For example, on my house mortgage (in 1991), the nominal rate of interest was 10%. That's the rate that was written in my loan contract.

MY REAL INTEREST: In 1991, I paid interest of 10% on the outstanding principle of my mortgage, but the rate of inflation was about 5%, so I will pay the remaining balance back in dollars worth 5% less -- a gain to me. The difference, 10%-5%=5% is the real interest I paid.
THE BANKER'S REAL INTEREST: Similarly, the bank made 10% interest, but lost 5% of the purchasing power of the remaining balance for a net gain of 5%.

Thus, from either point of view, the real rate of return on my mortgage was 5% -- the net of the nominal interest minus the rate of inflation.

Nominal interest: Nominal interest is the rate of interest specified in loan contracts, without adjustment for inflation.
Real interest: The real interest rate is the nominal interest rate minus the rate of inflation, and thus is the interest rate adjusted for inflation.

From now on, when we talk about interest, we are talking about the real rate of interest, unless we say otherwise.

What Determines the Rate of Interest?