Nominal Interest Rate vs Real Interest Rate

Interest rates play an important role in the economy. They affect borrowing, saving, investment, and overall economic growth. For competitive exams, two terms are repeatedly asked—Nominal Interest Rate and Real Interest Rate. Many students get confused, but the difference is actually very simple.

What is Nominal Interest Rate?

The Nominal Interest Rate is the interest rate quoted by banks or financial institutions.
It does not consider inflation.

Key Points

• Shown on bank documents, loan papers, and savings accounts
• Does not reflect the real value of money
• Can be misleading during high inflation

Simple Example

If a bank offers 10% interest on a savings account,
Nominal Interest Rate = 10%

But this does not tell you how much your money actually grows in terms of purchasing power.

What is Real Interest Rate?

The Real Interest Rate is the interest rate after adjusting for inflation.
It shows how much the purchasing power of your money truly increases.

Key Points

• Takes inflation into account
• Shows the actual benefit from savings or cost of loans
• Gives a clearer picture of economic conditions

Simple Formula (Fisher Equation)

Real Interest Rate = Nominal Interest Rate – Inflation Rate

Simple Example

If:

• Nominal Interest Rate = 10%

• Inflation Rate = 6%

Then:
Real Interest Rate = 10% – 6% = 4%

This means your actual earning is 4%, not 10%.

Difference Between Nominal & Real Interest Rate

1. Inflation Adjustment

• Nominal Rate: No adjustment

• Real Rate: Adjusts for inflation

2. Accuracy

• Nominal Rate: Gives a basic figure

• Real Rate: Shows actual financial gain or loss

3. Usefulness

• Nominal Rate: Important for loans, deposits, official announcements

• Real Rate: Important for understanding purchasing power and economic strength

4. Interpretation

• If inflation is high → Real Interest Rate falls

• If inflation is low → Real Interest Rate rises

Why Real Interest Rate Matters More

1. For Savings

If inflation is higher than the interest you earn,
your savings lose value.

2. For Loans

A borrower benefits when inflation is high because the real cost of borrowing becomes lower.

3. For Government & RBI

Real interest rates help in planning monetary policy, controlling inflation, and maintaining economic stability.

Example for Better Understanding

This shows that actual gain or loss depends on real interest, not nominal.