What do we Mean by Nominal Interest Rate?
Interest rate is the rate at which a lender charges the interest to a borrower for a particular time period for the sum of money he provides as a loan. Interest is the charge for using the funds of the lender. The nominal interest rate is the simple rate of interest that a lender charges on loan without considering the effect of inflation, fees, charges, and the compounding of interest. Expression of this interest rate happens as a percentage of the loan amount.
The Central Banks of countries across the world use the nominal interest rate as a base rate. And this rate only forms the base for all their communications. Other banks and financial institutions use this base rate to charge their interest rates on their offerings. This base rate serves as an important tool in setting the monetary policy in a country. The point to note here is that this base rate or nominal interest rate, however, does not consider the purchasing power erosion that inflation causes in an economy. Also, this rate ignores the effect of fees and commissions that the banks and financial institutions charge for their services. Similarly, this rate does not give us the real return on loan caused by the compounding power of money.
- What do we Mean by Nominal Interest Rate?
- What is the Use of the Nominal Interest Rate?
- How do we Adjust the Nominal Interest Rate for Inflation?
- What are the Limitations of the Nominal Interest Rate?
What is the Use of the Nominal Interest Rate?
A nominal interest rate is an important tool in monetary policy formulation and implementation. Using this rate as a monetary policy tool, the Central Banks control the supply and demand of money in the economy. In the recessionary phases of the economy, they lower this nominal rate. The banks are able to borrow from the Central bank at low rates of interest. And then pass this benefit of lower interest to the consumers as well. Lower rates of interest act as a stimulant and encourage the households to borrow more, spend more, and invest more. This, in turn, boosts consumption, improves the money flow in the economy, and pulls it out of recession.
The Central banks do the exact opposite in times of inflationary periods in the economy. They increase the nominal rate of interest, which makes borrowing more expensive for commercial banks and financial institutions. They pass on this higher rate of interest to their consumers. Henceforth, individuals and companies cut down on borrowing, spending, and investments. This brings down the demand for money and lowers the money flow in the economy. Thus, it helps to control the inflationary trends in the economy.
How do we Adjust the Nominal Interest Rate for Inflation?
The prominent economist Irving Fisher has appropriately described the relationship between nominal interest rate and inflation through his theory- the Fisher Effect. According to him, the real interest rate that an individual or company bears is the sum of the nominal interest rate and the rate of inflation in the economy. This relationship has been described with the help of the following equation:
(1 + r)= (1 +R) (1 +i)
Here, r= nominal interest rate, R= Real interest rate, and i= expected inflation rate.
Let us assume that an investor wants to earn a real interest rate of 10% p.a. on his investment. The current rate of inflation in the economy is 4%. Therefore, the minimum nominal interest rate that he should look for in any investment avenue can be calculated as:
r= (1 + 10%)(1+4%)
= 14 % p.a.
We can calculate this roughly by adding the inflation rate to the real interest rate and arriving at the answer. Alternatively, we can also understand the effect of inflation on the returns of an investor with the help of the same above example.
Suppose an investor is earning a nominal interest rate of 14% p.a. on an investment avenue. The expected rate of inflation is 4% p.a. In that case, he will be actually earning a return of roughly 14% – 4%= 10% p.a. only. This will be the real interest rate that he earns on his investment.
What are the Limitations of the Nominal Interest Rate?
Ignores the Effect of Inflation
One of the most important limitations of the Nominal interest rate is that it ignores the effect of inflation. Investors or borrowers who blindly rely upon this rate and do not take into account the effect of inflation will end up losing a lot of money if the rate of inflation is considerably high in the economy.
An inflation rate of 6% will effectively reduce the purchasing power of the borrower by that amount because it makes the goods and services in the economy costlier to that extent. Hence, the investor will effectively need more money to buy the same quantity of goods that he used to buy earlier. Thus, inflation results in a fall in the value of money/purchasing power. An investor should always consider the effect of inflation on his investment to arrive at the true returns from an investment. Suppose an investment promises a return at a nominal interest rate of 10%, and the rate of inflation in the economy over that period was 6%. In that case, his real or effective return will just be 4% (10% – 6%).
Ignores the Effect of Compounding
Another limitation of this rate of interest is that it ignores the effect of compounding. We cannot compare two or more investment options until their compounding periods are the same. This can be understood well with the help of the following equation:
R= (1+ r/n)*n – 1
Here, R= Effective interest rate, r = nominal interest rate, and n= number of periods of compounding in a year.
Suppose an investment provides a nominal interest rate of 5%, and the interest is compounded annually. We can calculate the effective rate of interest with the help of the above example.
R= (1 + 5%/2)*2 – 1
Thus, it is higher than the nominal interest rate. An investor should take the effective interest rate into account and not the nominal interest rate to arrive at the true returns from an investment.
Ignores the Effect of Fees and Commissions
The nominal interest rate also ignores the effect of fees, charges, and commissions that a bank or lending institution charges for its services. An investor should reduce these charges and expenses from his returns to arrive at his true return from that investment. At times all these charges constitute a heavy amount. And thus may substantially reduce the effective return on the investment. Or increase the effective rate of interest on borrowings.
The nominal interest rate acts as a base rate for the rate of interest that other financial institutions charge on their loans. Hence, it should be carefully set by the Central banks. Because it affects the entire economy. It directly impacts the volume of money in circulation in the economy. And also helps to control complex situations such as inflation and recession.
However, this rate of interest has some limitations as well as discussed above. An investor should consider various factors, such as the effect of inflation, compounding, etc., to determine the true returns from an investment. This will help him to arrive at the real interest rate that he will earn from various investment options and choose the best among them.