You should know what nominal and real interest rates are
Nominal Interest rate and Real interest rate
Banks are a great place to keep money, apart from convenience, you earn interest for parking your money with the bank. How much interest you earn depends on the interest rate? Interest rates are of two types: nominal and real.
Nominal interest rate
The nominal interest rate (advertised rate) calculates the amount you will earn in a year or quarter based on your average account balance for that year or quarter.
For example, Mr. Waldek decides to open a savings account with Good Bank Ltd.
The Good bank asks, “How much are you going to deposit, Mr. Waldek? ”Our bank offers the highest interest rate: 8%. “Yes, I know that. That’s why I chose your bank,” said Mr. Waldek. I am depositing $5000.
Now Mr. Waldek will earn every year $400 considering an 8% interest rate and an average yearly account balance of $5000. The 8% is the nominal interest rate.
Mr. Waldek drives back home with his favorite music on in his car. “I have invested with a bank that offers me 8%,” thinks Mr. Waldek.
But is the 8% interest rate that good? Basic knowledge of economics would have helped him to understand what’s happening.
Real Interest rate
The real interest rate is the nominal interest rate minus inflation.
The nominal interest rate is the pawn that carries out a crime, and the mastermind of the crime is the real interest rate.
For example, If 10% is the inflation in the Waldek case, then the real interest rate comes to:
8%-10%= -2%
Think of the real interest rate in terms of the ability of $ to buy goods. Today an apple costs $10, so Mr. Waldek, with his $5000, can buy 500 apples.
But with inflation at 10%, the same apple will cost $11 after a year. Adding his interest-earning $400, he gets $5400 at the end of a year.
The $5400 can get him 490.90 apples and not 500 apples, So, in terms of goods, he is losing money even though it appears that he earned $400 over a year.
“Good Bank isn’t really that Good”
