ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

Difference between real and nominal rates of interest.

Updated on October 23, 2009

Nominal interest rates measure the rate at which money invested grows. If you invest £1,000 in a bank account at a nominal rate of 10% the bank promises to pay £1,100 at the end of the year. The nominal rate of interest offered by the bank is certain but the bank makes no promises on what the £1,100 can actually buy. This is because prices of goods and services change; an overall sustained increase in general prices is called inflation.

Thus the real rate of interest is the nominal interest rate adjusted for inflation. The real rate of interest therefore measures the real value of the £1,100 invested in terms of its buying power. If inflation is 5% then a bar of chocolate that costs £1.00 last year will now cost £1.05. Inflation leads to the decline in the value of your money in terms of what you can purchase.

For example if inflation is 5% and the nominal rate of interest is 10% on a bank account the real interest rate based on approximation is 10% - 5% = 5% therefore the real value of a £1,000 invested for a year will be £1,050.

The formula for calculating the accurate real rate of interest is:

1 + real interest rate = 1 + nominal rate

1 + inflation

= 0.047 / 4.7% real rate of interest

Therefore the nominal interest rate is expressed in money terms and the real rate of interest is the buying power of money.

Do changes in nominal interest rate only have an impact on the firm’s investment decisions if they are accompanied by a change in real interest rate?

Based on the assumption that firms use the real rate of interest as a discount rate to evaluate the NPV of projects, any change in nominal rates of interest should be adjusted for inflation to give the real rate of interest.

Inflation is an important factor that can have a big impact on future cash flows, so need to be considered when making investment decisions.

For example if a company was evaluating the following project K:

Yr 0

Outlay

£10,000

Yr 1

Cash flow 1

£5,000

Yr 2

Cash flow 2

£5,800

Scenario 1

Discount rate = real rate approximation:

q 10% nominal interest rate / 5% inflation

q 10% - 5% = 5 % real rate of interest (approx)

Year

Cash flow

PV at 5%

Yr 0

(£10,000)

(£10,000)

Yr 1

£5,000

£4,761

Yr 2

£5,800

£5,261

NPV

£22 Accept

Scenario 2

If there is a 1% increase in nominal interest rate and inflation is constant it will have an impact on the firms decision as the real rate of interest has increased by 1% to 6%.

Year

Cash flow

PV at 6%

Yr 0

(£10,000)

(£10,000)

Yr 1

£5,000

£4,716

Yr 2

£5,800

£5,162

NPV

(£122) Reject

In this case the real rate of interest has changed to 6%, which has lead to a negative NPV and will result in the company’s rejecting this project.

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://hubpages.com/privacy-policy#gdpr

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)