What is Nominal Interest Rate?
Nominal interest rate refers to the interest rate before taking inflation into account. It can also refer to the advertised or stated interest rate on a loan, without considering any fees or compounding of interest.
Key Takeaways
- Nominal interest rate refers to the interest rate before considering inflation.
- The federal funds rate, set by the Federal Reserve, is a short-term nominal interest rate that influences other interest rates charged by banks and financial institutions.
- Investors focus on real interest rates, which consider inflation, to avoid purchasing power erosion.
- The annual percentage yield (APY) is the effective interest rate, which usually holds more relevance to borrowers and lenders than the nominal rate.
Discovering Nominal Interest Rates
Central banks set short-term nominal interest rates that form the base for other rates charged by banks and financial institutions. During economic crises, central banks may keep nominal interest rates low to spur economic activity by encouraging loans and consumer spending. However, for these measures to work, inflation should not be a current or near-term threat.
During periods of inflation, central banks usually set higher nominal rates to control purchasing power and inflation. However, setting rates too high may stall economic activities by discouraging spending.
Nominal vs. Real Interest Rates
Unlike nominal rates, real interest rates account for inflation. The approximate equation linking nominal and real interest rates is:
Nominal rate = Real interest rate + Inflation rate
To avoid purchasing power erosion through inflation, investors usually consider the real interest rate. For example, Treasury Inflation-Protected Securities (TIPS) offer a way to preserve savings without losing value due to inflation.
Calculating Effective Interest Rates
Although the nominal rate is the stated rate of a loan, it often differs from what the consumer actually pays due to fees and compounding. The formula for effective interest rate (e) is given by:
e = (1 + n/m) ^ m - 1
where:
nis the nominal ratemis the number of compounding periods
For instance, if a loan’s nominal rate is 8% compounded semi-annually, the effective interest rate would be:
e = (1 + 0.08/2) ^ 2 - 1 = 8.16%
Embracing the Effective Interest Rate (APY)
The annual percentage yield (APY) is the effective interest rate, including fees and compounding. The APY tends to be more relevant to borrowers and lenders than the nominal rate. To calculate the effective rate from the nominal rate, the formula is:
e = (1 + n/m) ^ m - 1
Conclusion
Understanding the nuances between nominal, real, and effective interest rates is essential for informed financial decision-making. Comprehending how these rates are influenced by central financial policies can offer clarity on investment returns, loan repayments, and overall economic health.
Related Terms: effective interest rate, real interest rate, annual percentage yield (APY), federal funds rate, Consumer Price Index (CPI)
References
- Federal Reserve Bank of San Francisco. “How Does Monetary Policy Affect the U.S. Economy?”.
- Treasury Direct. “TIPS in Depth”.
- U.S. Department of the Treasury. “Daily Treasury Real Yield Curve Rates”.
