The most important characteristic of the modern economy is the depreciation of investments through inflationary processes. This fact makes it advisable to use not only the nominal, but also the real interest rate when making some decisions on the loan capital market. What is the interest rate? What does it depend on? How to determine the real interest rate?
Interest rate concept
The interest rate should be understood as the most important economic category, reflecting the profitability of an asset in real terms. It is important to note that it is the interest rate that plays the decisive role in the process of making managerial decisions, because any economic entity is very interested in obtaining the maximum level of revenue at the minimum cost in the process of its activity. In addition, each entrepreneur, as a rule, reacts to the dynamics of the interest rate in an individual way, because in this case the determining factor is the type of activity and the industry in which, for example, the production of a company is concentrated.
Thus, the owners of capital funds often agree to work only under the condition of an extremely high level of interest rates, and borrowers are likely to acquire capital only in case of low interest. The examples considered are clear evidence that today it is very difficult to find equilibrium in the capital market.
Interest Rates and Inflation
The most important characteristic of a market economy is the presence of inflation, which determines the classification of interest rates (and, of course, the rate of return) on nominal and real. This allows you to fully evaluate the effectiveness of financial transactions. If the inflation rate is exceeded in relation to the interest rate received by the investor on investments, the result from the corresponding operation will be negative. Of course, in terms of absolute value, his funds will increase significantly, that is, for example, he will have more money in rubles, but his purchasing power, characteristic of them, will drop significantly. This will lead to the opportunity for a new amount to buy only a certain amount of goods (services), less than would be possible before the start of this operation.
Distinctive features of nominal and real rates
As it turned out, the nominal and real interest rates differ only in conditions of inflation or deflation. By inflation should be understood a significant and sharp increase in prices, and by deflation - their significant drop. Thus, the nominal rate is the rate assigned by the bank, and the real interest rate is the purchasing power inherent in income and denoted as a percentage. In other words, the real interest rate can be defined as the nominal one, which is adjusted for the inflationary process.
Irving Fisher, an American economist, formulated a hypothesis explaining how the level of real interest rates depends on the nominal. The main idea of the Fisher effect (the hypothesis is called this way) is that the nominal interest rate tends to change in such a way that the real one remains “motionless”: r (n) = r (p) + i. The first indicator of this formula displays the nominal interest rate, the second - the real interest rate, and the third element is equal to the expected rate of inflation, expressed as a percentage.
The real interest rate is …
A striking example of the Fisher effect, discussed in the previous chapter, is the picture when the expected rate of the inflationary process is equal to one percent in annual terms. Then the nominal interest rate will also increase by one percent. But the real percentage will remain unchanged. This proves that the real interest rate is the same nominal interest rate, but minus the estimated or actual inflation rates. This rate is fully cleared of inflation.
Indicator calculation
The real interest rate can be calculated as the difference between the nominal interest rate and the level of inflationary processes. Thus, the real interest rate is equal to the following ratio: r (p) = (1 + r (n)) / (1 + i) - 1, where the calculated indicator corresponds to the real interest rate, the second unknown member of the ratio determines the nominal interest rate, and the third element characterizes the level of inflation.
Nominal interest rate
In the process of talking about credit rates, as a rule, we are talking about real rates (the real interest rate is the purchasing power of income). But the fact is that they cannot be observed directly. So, when concluding a loan agreement, the economic entity is provided with information on nominal interest rates.
The nominal interest rate should be understood as a practical characteristic of interest in quantitative terms, taking into account current prices. At this rate, a loan is issued. It should be noted that it cannot be greater than zero or equal to it. The only exception is a loan on a free basis. The nominal interest rate is nothing more than interest expressed in monetary terms.
Calculation of the nominal interest rate
Suppose, in accordance with an annual loan of ten thousand monetary units, 1, 200 monetary units are paid as interest. Then the nominal interest rate is equal to twelve percent per annum. After receiving a loan of 1200 monetary units, will the lender get rich? You can correctly answer this question only by knowing exactly how prices will change during the annual period. Thus, with an annual inflation of eight percent, the lender’s income will only increase by four percent.
The calculation of the nominal interest rate is carried out as follows: r = (1 + percentage of income received by the bank) * (1 + increase in the inflation rate) - 1 or R = (1 + r) × (1 + a), where the nominal interest rate is the main indicator the second is the real interest rate, and the third is the growth rate of the inflation rate in the country that is calculated.
