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Putting a Price on the Future
Since inflation reduces the value of the payment of a loan, economists have to be able to distinguish between the nominal interest rates and the real ones. Nominal interest rates are simply interest rates that you are used to; they measure the returns of a loan in terms of money that is taken in a loan and how it is paid back. Real interest rates, however, keep inflation in mind, measuring the returns of a loan in terms of money that is taken in a loan in terms of units of borrowed things and units of things given back. This distinction is very important because the real interest rate is what makes people want to save and invest. After all what lenders are really interested in is not the amount of money that is given back to them, but on what they can buy with it.
Let’s suppose that you borrow $1000 and you make a promise to give back $1,100 to the lender the next year. Your nominal interest rate is ten percent because you are paying $100 more, or ten percent more dollars than what you borrowed. However if there were to be an inflation, the amount of things that $100 could buy would diminish in time.
Lets say for example that you for a good meal for two with a bottle of wine costs $100 but it will cost $105 the next year. Right now the lender is sacrificing ten of those great meals, $1,000 divided by $100 per meal, in order to make the loan. The next year when he receives the $1,100 he can buy 10,47 meals at the price of $105. He is now giving up 10 meals in exchange for 10,47 meals the next year, in other words the real interest rate is 4,7 percent. As a consequence of inflation, the real interest rate is substantially less than the nominal rate.