Interest Rates, Nominal

views updated

Interest Rates, Nominal

The nominal rate of interest is the rate (usually per year) stated as the interest rate paid. If a lender charges fees of one sort or another, then the nominal rate is less than the actual rate of interest, where interest is defined as the price of the loan. Also, when interest is paid more than once a year, the nominal rate is less than the actual rate of interest received. For example, if money is lent at 8 percent for a year with the interest paid quarterly, 2 percent of the amount lent will be paid each quarter. Sometimes, the interest is compounded, that is, not paid but added to the principal amount and interest paid on the interest. In this case, the actual rate of interest received is approximately 8.24 percent. However, even if the interest is paid quarterly, the lender has the use of the money received and could lend it to another borrower, so that effectively the rate of interest is the same as when interest is compounded.

In many circumstances, the greatest weakness in using the nominal rate of interest in decision making is that it does not take into account the loss of purchasing power due to inflation. Thus, if in the example above there is 3 percent inflation over the year, after allowing for the loss of purchasing power the lender only receives as interest 5.24 percent of the amount lent. This figure is known as the real rate of interest and the difference between it and the nominal rate is called the inflation tax. If the loan is to the government, the inflation tax is indeed a tax. If it is to a person or institution in the private sector, it equally represents a transfer of real income from the lender to the borrower. Moreover, even if those participating in financial markets took into account the inflation tax and the rate of interest adjusted accordingly, all of the interest that the lender would receive would be subject to income tax, although part of it is not income but compensation for the loss of the purchasing power of the amount lent. It is possible to overcome to some extent these deficiencies in the nominal rate of interest by indexing the amount lent to a measure of the inflation rate, but this is not usually done.

In economic theory, the rate of interest used is usually, either implicitly or explicitly, the real rate of interest. It is assumed that the inflation tax is quickly taken into account by borrowers and lenders, and that the nominal rate of interest rises and falls more or less equally with the rate of inflation. The amounts lent and borrowed and the real incomes of lenders and borrowers are not changed, at least if the effects of income taxes are ignored. The use of the nominal rate of interest in contracts in the real world is mainly considered by theorists in the context of the effects of the taxation system on peoples’ decisions. However, in the world of this economic theory, not only does everything happen quickly, there is also perfect knowledge. In the real world, neither of these conditions holds. Empirical research shows that nominal rates do not usually adjust quickly and fully when the rate of inflation changes. Nominal rates do rise and fall with inflation to some extent, but often slowly and rarely to the full extent, at least for decades. Sometimes a rise in interest rates may even come before the rise in inflation rates. Raising interest rates is the principal weapon central banks use to combat inflation, which is usually their most important concern. The lags in monetary policy are notoriously long, and central banks sometimes make a preemptive rise in interest rates when they expect a rise in inflation. When the inflation rate is falling, the reverse could occur. However, because of their great concern about inflation, central banks are often quicker to raise rates than to reduce them.

The use of the nominal rate of interest causes inefficiencies in the operation of the economy by subsidizing borrowers at the expense of lenders. Its use in monetary policy may have undesirable consequences for the distribution of income. If the rate of inflation is stable and relatively low, these consequences are small, but the more these two conditions are broken, the more important are the consequences of using the nominal rate of interest.

SEE ALSO Central Banks; Equity Markets; Federal Reserve System, U.S.; Inflation; Interest Rates; Interest, Real Rate of; Money; Policy, Monetary; Stock Exchanges