Nominal Interest

(noun)

The amount of interest accrued per year without accounting for compounding.

Related Terms

Examples of Nominal Interest in the following topics:

  • Differences Between Real and Nominal Rates

    • The real rate is the nominal rate minus inflation.
    • In the case of a loan, it is this real interest that the lender receives as income.
    • If the lender is receiving 8% from a loan and inflation is 8%, then the real rate of interest is zero, because nominal interest and inflation are equal.
    • The real rate can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate: 1 + i = (1+r) (1+E(r)), where i = nominal interest rate; r = real interest rate; E(r) = expected inflation rate.
    • The relationship between real and nominal interest rates is captured by the formula.

  • The Fisher Effect

    • We only discussed nominal interest rates.
    • We did not adjust the nominal interest rates for inflation.
    • The Fisher Effect relates nominal and real interest rates and we define the notation as:
    • Financial analysts always write interest rates for financial instruments in nominal terms.
    • If investors and the public have higher expectations of inflations ( πe ), then nominal interest rates (i) become greater.

  • Comparing Interest Rates

    • The reason why the nominal interest rate is only part of the story is due to compounding.
    • Since interest compounds, the amount of interest actually accrued may be different than the nominal amount.
    • To find the real interest rate, simply subtract the expected inflation rate from the nominal interest rate.
    • Thus, Company 2 is the better investment, even though Company 1 pays a higher nominal interest rate.
    • The nominal interest rate is approximately the sum of the real interest rate and inflation.

  • Macroeconomic Factors Influencing the Interest Rate

    • In economics, a Taylor rule is a monetary-policy rule that stipulates how much the Central Bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions.
    • In particular, the rule stipulates that for each 1% increase in inflation, the Central Bank should raise the nominal interest rate by more than one percentage point.
    • According to Taylor's original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:
    • In this equation, it is the target short-term nominal interest rate (e.g., the federal fund rates in the United States), πt is the rate of inflation as measured by the GDP deflator, π*t is the desired rate of inflation, r*t is the assumed equilibrium real interest rate, yt is the logarithm of real GDP, and y*t is the logarithm of potential output, as determined by a linear trend.
    • Describe how the nominal interest rate is influenced by inflation, output, and other economic conditions

  • Calculating Values for Different Durations of Compounding Periods

    • The EAR can be found through the formula in where i is the nominal interest rate and n is the number of times the interest compounds per year (for continuous compounding, see ).
    • You can think of it as 2% interest accruing every quarter, but since the interest compounds, the amount of interest that actually accrues is slightly more than 8%.
    • In this equation, A(t) corresponds to FV, A0 corresponds to Present Value, r is the nominal interest rate, n is the number of compounding periods per year, and t is the number of years.
    • The equation follows the same logic as the standard formula. r/n is simply the nominal interest per compounding period, and nt represents the total number of compounding periods.
    • Finding the FV (A(t)) given the PV (Ao), nominal interest rate (r), number of compounding periods per year (n), and number of years (t).

  • Calculating the Yield of a Single-Period Investment

    • Nominal APR is simply the interest rate multiplied by the number of payment periods per year.
    • However, since interest compounds, nominal APR is not a very accurate measure of the amount of interest you actually accrue.
    • Interest usually compounds, so there is a difference between the nominal interest rate (e.g. monthly interest times 12) and the effective interest rate.
    • The Annual Percentage Yield is a way or normalizing the nominal interest rate.
    • Basically, it is a way to account for the time factor in order to get a more accurate number for the actual interest rate.inom is the nominal interest rate.N is the number of compounding periods per year.

  • Inflation Premium

    • An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels.
    • Actual interest rates (without factoring in inflation) are viewed by economists and investors as being the nominal (stated) interest rate minus the inflation premium.
    • The Fisher equation in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation.
    • In economics, this equation is used to predict nominal and real interest rate behavior.
    • Letting r denote the real interest rate, i denote the nominal interest rate, and let π denote the inflation rate, the Fisher equation is: i = r + π.

  • Drivers of Market Interest Rates

    • A market interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.
    • In a free market there will be a positive interest rate.
    • Different investments effectively compete for funds, boosting the market interest rate up.
    • The greater the risk is, the higher the market interest rate will get.
    • where in is the nominal interest rate on a given investment, ir is the risk-free return to capital, pe = inflationary expectations, i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.

  • International Fisher Effect

    • The Fisher Effect relates the nominal interest rate to the rate of inflation and real interest rate.
    • For example, if the expected inflation, $\pi$, is 10% and nominal interest rate, i, equals 5%, subsequently, the real interest rate is approximately -5%.
    • The International Fisher Effect relates the real interest rate to a nominal interest rate in a foreign country.
    • Domestic nominal interest rate in APR is id, while rd represents the domestic rate of return of the investment in T days.
    • Foreign nominal interest in APR rate for an investment for T days is if.

  • Chapter Questions

    • Calculate the real interest rate if the nominal interest rate equals 90% while the inflation rate is 100%.
    • Draw a loanable funds market with an equilibrium interest rate of 7%.
    • What would happen if the world's interest rate is 9%?
    • Draw a loanable funds market with an equilibrium interest rate of 7%.
    • What would happen if the world's interest rate is 5%?