MAcro CHAPTER 4.2:

CHAPTER SUMMARY

Earning interest on our investments is great because it means our purchasing power increases, instead of staying the same. However, while a 50% interest rate might sound amazing, it's not so great if the inflation rate is also 50%. That means that, while the amount of money I have is increasing, I'm not actually getting any more purchasing power.

This is why we differentiate between nominal interest rates and real interest rates. A nominal interest rate is the extra percentage of money that you will receive as interest. Real interest rate is this percentage minus inflation, which tells me the actual increase in my purchasing power. The formula is:

Real IR = Nominal IR - Inflation rate

In my previous example, the real interest rate was 0%, because both nominal interest rate and the inflation rate were the same. If nominal interest is 5% and the inflation rate is 3%, my real interest rate is 2%. If nominal interest is 5% and the inflation rate is 9%, my real interest rate is -4%, and my purchasing power is actually decreasing.

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