Finance and the Economy · Seminar 7 · Finance for business

Correcting an interest rate for inflation

The nominal rate is what the market quotes; the real rate is what the money buys. Subtracting inflation is a quick approximation; dividing (1 + nominal) by (1 + inflation) is exact. Questions 5(c) and 6(b).

Pick a question, or set the nominal rate and inflation. The chart shows the real rate at every inflation rate for your nominal rate, both ways.
0%30%
0%15%

Approximate real rate

Exact real rate

Difference

Reading

The Fisher relationship. (1 + real) × (1 + inflation) = 1 + nominal. Lenders add an inflation premium to the real return they require; borrowers repay in money that buys less. The approximation is good when both rates are small, and drifts as they grow.

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