What is the difference between nominal and real rates?

1 Nominal rate

The nominal rate is the interest rate or the return on an investment that is stated without adjusting for inflation. For example, if you lend $100 to someone and agree to receive $105 after one year, the nominal interest rate is 5%. The nominal rate does not reflect the purchasing power of money, which may change due to inflation or deflation. In other words, the nominal rate does not tell you how much more or less goods and services you can buy with the money you receive in the future.

2 Real rate

The real rate is the interest rate or the return on an investment that is adjusted for inflation. It reflects the change in the purchasing power of money over time. For example, if the inflation rate is 2% per year, the real interest rate on the same loan of $100 is 3%. The real rate tells you how much more or less goods and services you can buy with the money you receive in the future compared to the present. The real rate is calculated by subtracting the inflation rate from the nominal rate.

3 Fisher equation

The Fisher equation is a formula that relates the nominal and real rates and the inflation rate. It states that the nominal rate is equal to the sum of the real rate and the inflation rate, plus the product of the real rate and the inflation rate. In symbols, it is written as: nominal rate = real rate + inflation rate + (real rate x inflation rate) The Fisher equation shows that the nominal rate is always higher than the real rate, unless there is deflation. It also shows that the difference between the nominal and real rates increases as the inflation rate or the real rate increases.

4 Nominal and real cash flows

When you evaluate an investment project, you need to consider the nominal and real cash flows. Nominal cash flows are the cash inflows and outflows that are expected to occur at the nominal rates. Real cash flows are the cash inflows and outflows that are adjusted for inflation at the real rates. For example, if you invest $1000 in a project that promises to pay you $200 per year for five years, the nominal cash flow is $200 per year. But if the inflation rate is 3% per year, the real cash flow is $194.17 in the first year, $188.51 in the second year, and so on.

5 Nominal and real discount rates

When you calculate the net present value (NPV) or the internal rate of return (IRR) of an investment project, you need to use the appropriate discount rate. The discount rate is the interest rate or the return that you require to invest in the project. You can use either the nominal or the real discount rate, but you have to be consistent with the cash flows. If you use the nominal cash flows, you have to use the nominal discount rate. If you use the real cash flows, you have to use the real discount rate. The nominal and real discount rates are related by the Fisher equation. For example, if the real discount rate is 10% and the inflation rate is 5%, the nominal discount rate is 15.5%.

6 Why it matters

Understanding the difference between nominal and real rates is important for accounting and finance because it affects the value of money over time and the profitability of investment projects. If you ignore the effects of inflation, you may overestimate or underestimate the true return or cost of an investment. You may also make wrong decisions based on misleading indicators. Therefore, you should always use the nominal and real rates correctly and consistently when you deal with capital budgeting and cost of capital issues.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?