The Real and Nominal Interest Rate

A small business owner, John, transfers ten thousand dollars from his earnings into a savings account. The bank offers a three percent annual interest rate, so his balance grows to ten thousand three hundred dollars after one year.

At first glance, it seems John earned three hundred dollars. This amount results from the nominal interest rate of three percent—the return before adjusting for inflation.

But during that same year, inflation reached 2%. Something that cost one hundred dollars now costs one hundred and two, showing how each dollar buys a little less.

Economists use a simple formula to find the real interest rate, a better indicator of actual earnings. The real interest rate is equal to the nominal interest rate minus the inflation rate, which measures the real gain. In John’s case, the real rate is one percent.

So, while his account balance increased by three percent, his real gain in purchasing power was only one percent, reflecting what his money could actually buy.

Now imagine if inflation rose to four percent. Despite the higher balance, John would face a negative real interest rate of minus one percent, meaning his money would lose value in real terms.

Understanding real interest rates is key to measuring actual financial growth.