Nominal interest (rN) rate is the interest that does not take inflation (i) into account vs real interest (rR) does. This is the main difference between nominal and real interest rates. Nominal interest rates are used in real life financial contracts such as bonds, loans etc. but since there is a phenomenon of inflation in real world, we have to take inflation into account when we are calculating the real interest. We can use below formula to calculate real interest rate if we know the nominal rate and expected inflation.
rR = (1 + rN) / (1 + i) – 1
This formula is called Fisher Equation which named after famous economist Irving Fisher.
To make it more easy to understand, let’s make a simple example:
Assume that nominal interest rate is 15% and expected inflation is 7%, with that information we can easily find real interest rate.
rR = (1 + 0.15) / (1 + 0.07) – 1 = 0.0748 which is around 7.48%.
Additionally, there is International Fisher Effect which is a theory showing the relationship between exchange rate of currencies (or inflation) and related country interest rates. The theory suggests that differences in two countries interest rates (inflation) are reflected in exchange rate of those countries. The currency with the higher inflation will be devalued compared to other country currency. To understand better we can do a simple example.
Assume that Country A (currency A) has an annual inflation of 3% and Country B (currency B) has an annual inflation of 10%, given that the spot rate is Currency A / Currency B = 2, what would be the rate after 1 year?
Using the formula of;
Currency A / Currency B = (1 + inf B ) / (1 + inf A) * current spot rate
Currency A / Currency B = (1 + 0.10) / (1 + 0.03) * 2 = 2.136
As you see the rate has increased after 1 year since Country B’s inflation is higher than the other country, so the Currency B has been devalued compared to Currency A.
If you have any questions please comment below.
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