What is the key difference between nominal and real interest rates?

The key difference between nominal and real interest rates is that the real interest rate factors in inflation, providing a clearer picture of the true cost of borrowing and the true yield on savings. Nominal interest rates refer to the stated interest rate without adjusting for inflation, which means they may not accurately reflect the purchasing power of money over time. In contrast, the real interest rate is calculated by taking the nominal rate and subtracting the inflation rate, thus allowing individuals and businesses to understand how much their money will actually grow in terms of purchasing power.

This distinction is important in economic decision-making; for example, if inflation is high, the nominal interest rate may appear attractive at first glance, but once inflation is considered, the real rate could be much lower, leading to different investment and savings behaviors. By recognizing the impact of inflation, the real interest rate provides a more realistic assessment of investment opportunities and financial planning.