You should know what nominal and real interest rates are

Summary

The provided text explains the difference between nominal and real interest rates, emphasizing that the real rate reflects purchasing power after accounting for inflation.

Abstract

The article titled "You should know what nominal and real interest rates are" distinguishes between nominal and real interest rates. It illustrates that while the nominal interest rate is the advertised rate at which money in a savings account grows, the real interest rate is what one actually earns after subtracting inflation. For instance, Mr. Waldek, who deposits $5000 at an 8% nominal interest rate with Good Bank Ltd., would expect to earn$ 400 annually. However, if inflation is 10%, his real interest rate would be -2%, meaning his purchasing power decreases despite earning interest. The article suggests that understanding this concept is crucial for making informed financial decisions, as the nominal rate can be misleading without considering the impact of inflation.

Opinions

The article implies that basic knowledge of economics is important for individuals to fully understand the implications of interest rates on their savings.
It subtly criticizes banks for advertising nominal interest rates without adequately explaining the impact of inflation, potentially misleading customers like Mr. Waldek.
The author uses a real-world example to convey the idea that a high nominal interest rate does not necessarily equate to a favorable financial outcome once inflation is taken into account.
The article suggests that Good Bank Ltd. may not be as beneficial as it appears, highlighting the importance of looking beyond the advertised rates when choosing a savings account.

Nominal interest rate

The nominal interest rate (advertised rate) calculates the amount you will earn in a year or quarter based on your average account balance for that year or quarter.

For example, Mr. Waldek decides to open a savings account with Good Bank Ltd.

The Good bank asks, “How much are you going to deposit, Mr. Waldek? ”Our bank offers the highest interest rate: 8%. “Yes, I know that. That’s why I chose your bank,” said Mr. Waldek. I am depositing $5000.

Now Mr. Waldek will earn every year $400 considering an 8% interest rate and an average yearly account balance of $5000. The 8% is the nominal interest rate.

Mr. Waldek drives back home with his favorite music on in his car. “I have invested with a bank that offers me 8%,” thinks Mr. Waldek.

But is the 8% interest rate that good? Basic knowledge of economics would have helped him to understand what’s happening.

Real Interest rate

The real interest rate is the nominal interest rate minus inflation.

The nominal interest rate is the pawn that carries out a crime, and the mastermind of the crime is the real interest rate.

For example, If 10% is the inflation in the Waldek case, then the real interest rate comes to:

8%-10%= -2%

Think of the real interest rate in terms of the ability of $ to buy goods. Today an apple costs $10, so Mr. Waldek, with his $5000, can buy 500 apples.

But with inflation at 10%, the same apple will cost $11 after a year. Adding his interest-earning $400, he gets $5400 at the end of a year.

The $5400 can get him 490.90 apples and not 500 apples, So, in terms of goods, he is losing money even though it appears that he earned $400 over a year.

“Good Bank isn’t really that Good”

You should know what nominal and real interest rates are

Nominal Interest rate and Real interest rate

Nominal interest rate

Real Interest rate