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You likely hear the interest rate and inflation rate discussed all the time. But how are the two linked? We cover that in this video on the real interest rate.

You likely hear the interest rate and inflation rate discussed all the time. But how are the two linked?

We cover that in this video on the real interest rate.

First off, it’s important to note that the real interest rate is the nominal interest rate minus inflation.

Ok, but what’s the nominal interest rate?

When you go to a bank to get a loan, they charge you an interest rate. For simplicity, let’s say you’ve gotten a small loan of $100 and the bank is charging you an interest rate of 10%. If you pay back the loan over a year, the bank will end up with $110 – $10 more than they loaned you.

Now, what we commonly call an “interest rate” is really the nominal interest rate. So that 10% is not taking inflation into account. If inflation for the year ends up being 10%, the bank doesn’t actually make a real return because of the decrease in the value of money.

Can you calculate the real interest rate on that $100 loan? Yep, it’s 0%.

In the video, we’ll cover the more complicated scenario of what happened in the U.S. in the 1970s when inflation was much higher than expected.

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What is the real interest rate? Well, first let's start with what the nominal interest rate is. That's the interest rate you see on a bank or credit card statement. So when people say interest rate, they usually mean nominal interest rate. To see the difference between nominal and real interest rates, let's turn to an example.


Suppose that a bank lends $100 at a nominal interest rate of 10%, but suppose also that over the year the inflation rate is 10%. At the end of that year, the borrower pays back the bank $110. That looks pretty good on paper, but during the year, money has become less valuable. Due to inflation, what used to cost $100 now costs $110. So what is the bank's real return? Zero.


More generally, we can write that the real interest rate is equal to the nominal rate, the rate charged on paper, minus the inflation rate. Inflation reduces the real return on a loan. So unexpected inflation can redistribute wealth from the lender to the borrower, and that's exactly what happened in the 1970s in the United States.


Suppose, for example, that you had taken out a home mortgage in the 1960s. As a borrower, you'd have done really well because few people anticipated the high inflation rates of the 1970s. So borrowers ended up paying off their mortgages in dollars that were worth a lot less than anyone had expected.


As you can see, in order to understand interest rates, understanding inflation is crucial. If you'd like to learn more about inflation, click here. Or, if you'd like to test your knowledge on the real interest rate, click here.


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