Alteration in genuine rate of interest
In the financial world, there's a limited-time offer for a savings subscription that might catch your eye. This offer doesn't bring any new information about real or nominal interest rates, but it's essential to understand these concepts to make informed decisions.
First, let's clarify the terms. A nominal interest rate is an unadjusted interest rate, while a real interest rate is one that has been adjusted for inflation. In simple terms, a nominal interest rate is the rate at which your money grows without considering the impact of inflation. A real interest rate, on the other hand, gives you an idea of the actual return on your investment after accounting for inflation.
Now, back to the offer. If you subscribe and try six free issues, you'll save an extra 10% on any subscription package. However, it's important to note that the advertised rate on this savings account will be the nominal one, not the real one. This means the rate doesn't take inflation into account, so its value may not be as impressive in periods of high inflation.
Inflation can significantly reduce the value of any future stream of income. For instance, if you have a bank account with £1,000 and a 2% nominal interest rate, it might look respectable if inflation is 1%, but less so if inflation is 3%.
On the other hand, index-linked government bonds have payments that increase in line with inflation. These bonds offer a real return, but their yields are typically lower than those of ordinary bonds due to the inflation adjustment.
The difference between the yield on these index-linked bonds and their non-indexed counterparts of similar maturities is a measure called the "break-even" rate. In the UK and USA, this break-even rate approximately matches the expected inflation rate. For example, the US Federal Reserve forecasts an average nominal interest rate of around 3.6% by the end of 2025, with an inflation target near 2%. This implies break-even real rates slightly above zero.
The formal definition of the real interest rate is given by the Fisher equation, calculated as (1+i)=(1+r)×(1+ π), where i is the nominal rate, r is the real rate, and π is the inflation rate. This equation shows the relationship between nominal and real interest rates.
In conclusion, understanding the difference between nominal and real interest rates is crucial when making financial decisions. The limited-time offer for the savings subscription provides a nominal interest rate, but it's essential to consider the impact of inflation when evaluating its worth.
