Question

Give clear definitions of the nominal and real interest rates on one year debt
contracts then briefly explain why it is that savers and investors respond to the real
rather than the nominal interest rate

Answer 1

A nominal interest rate is a interest rate before adjusting inflation into account.In simple terms it is a interest rate that does not include inflation rate in it.It will be a actual rate that has to be paid on the amount of fund borrowed irrespective of the inflation in the economy.It is a interest rate qouted on bonds and loans.

Whereas real interest rate is the interest rate that takes inflation into account.this means it adjust for inflation and gives the real rate of bond and loan.To calculate it we first need to find the nominal interest rate.

Real Rate of interest= Nominal rate of interest + Inflation

The savers and investors respond to real rate rather than the nominal interest rate because it is more effective and true as it include the effect of inflation in it.the real interest rate gives lenders and investors an idea of the real rate they receive after factoring inflation. This also gives them a better idea of the rate at which their purchasing power increase or decrease.They can estimate their real rate of return by comparing the difference between a treasury bond yield and a treasury inflation protected securities yield of the same maturity,which estimates inflation expectations in the economy.