nominal versus real interest rate

Your savings account pays 5% a year — sounds good. But suppose prices that year also rise 5%. At the end of the year you have 5% more money, yet everything costs 5% more, so you can buy exactly as much as before. You earned nothing in real terms. The gap between the interest you appear to earn and the interest you truly gain, once rising prices are taken out, is the difference between the nominal and the real interest rate.

The nominal interest rate is the headline rate, the percentage growth in the number of dollars — what the bank quotes. The real interest rate strips out inflation to show the growth in purchasing power, what your money can actually buy. A close-enough rule is: real rate = nominal rate minus the inflation rate. So 5% interest with 5% inflation gives a real rate of about 0%; 5% interest with 2% inflation gives a real rate of about 3%. (The exact version, the Fisher equation, accounts for the fact that inflation also erodes the interest itself, but subtraction is fine for everyday use.) Crucially, what matters for the borrower's burden and the saver's reward is the real rate, not the nominal one.

This distinction quietly shapes the whole economy. Borrowers love unexpected inflation, because they repay loans in money that buys less than the money they borrowed; lenders dislike it for the same reason, so they build expected inflation into the rates they charge. When the real interest rate is negative — nominal rates below inflation — cash and savings steadily lose value, nudging people to spend or invest instead. And because central banks try to influence the real rate to steer the economy, confusing the two rates is a classic mistake: a high nominal rate during high inflation can still be a low, even negative, real rate.