Many of us receive calls from telemarketers selling lifetime free credit cards. After understanding the product features, we straight away jump to the most important question. Are there any hidden charges or is it really free? Likewise, when it comes to interest rate, we should look at the hidden element – ‘Inflation’. Inflation is a silent killer who eats majority portion of your income. This lesson by Prof. Simply Simple attempts to explain the relationship between Nominal Interest Rate, Real Interest Rate and Inflation. Look forward to your valuable feedback at professor@tataamc.com

1. REAL VS. NOMINAL INTEREST RATE

2. The term “interest rate” is one of the
most commonly used phrases in day to
day finance. Today we will cover - Real
vs. Nominal Interest Rates.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

3. Let us see the formula of the Current Account Balance (CAB)
CAB = X - M + NI + NCT
X = Exports of goods and services
M = Imports of goods and services
NI = Net income abroad [Salaries paid or received,
credit / debit of income from
FII & FDI etc. ]
NCT = Net current transfers [Workers' Remittances
(unilateral), Donations,
Aids & Grants, Official,
Assistance and Pensions etc]
CURRENT ACCOUNT DEFICIT
The difference between nominal and
real interest rate is the key economic
factor – ‘Inflation’.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

4. Inflation is a rise in the general price
level. For instance, a 6% inflation rate
means that an average basket of goods
you purchased this year is 6% more
expensive as compared to last year.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

5. REAL INTEREST RATE VS. NOMINAL INTEREST RATE
Real Interest Rate is one where the effects of inflation have been factored
in.
Nominal Interest Rate is one where the effects of inflation have not been
accounted for.

6. Let us consider an example to
illustrate the difference :
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

7. REAL INTEREST RATE VS. NOMINAL INTEREST RATE
Suppose your fixed deposit of Rs. 100 earns 10% interest at the end of
the year.
This means the Rs. 100 at beginning of the year will become Rs. 110 at
the end of the year.
This 10% is the nominal interest rate, as we have not accounted for
inflation.

8. Let us see the formula of the Current Account Balance (CAB)
CAB = X - M + NI + NCT
X = Exports of goods and services
M = Imports of goods and services
NI = Net income abroad [Salaries paid or received,
credit / debit of income from
FII & FDI etc. ]
NCT = Net current transfers [Workers' Remittances
(unilateral), Donations,
Aids & Grants, Official,
Assistance and Pensions etc]
CURRENT ACCOUNT DEFICIT
Whenever people speak of the
interest rate they're talking about the
nominal interest rate, unless they
state otherwise.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

9. Assume that inflation rate is 6% for the year and your fixed deposit earns
10% nominal interest rate.
After factoring in inflation, your deposit will earn a real interest rate of 4%.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

10. COMPARING REAL & NOMINAL INTEREST RATE
REAL INTEREST RATE VS. NOMINAL INTEREST RATE
Nominal
Interest Rate
= 10%
Inflation = 6%
Real Interest Rate = 4%

11. Let us see the formula of the Current Account Balance (CAB)
CAB = X - M + NI + NCT
X = Exports of goods and services
M = Imports of goods and services
NI = Net income abroad [Salaries paid or received,
credit / debit of income from
FII & FDI etc. ]
NCT = Net current transfers [Workers' Remittances
(unilateral), Donations,
Aids & Grants, Official,
Assistance and Pensions etc]
CURRENT ACCOUNT DEFICIT
The relationship between nominal
interest rate, inflation, and real
interest rate is described by the
Fisher Equation:
REAL INTEREST RATE VS. NOMINAL INTEREST RATE
Real Interest Rate = Nominal Interest Rate – Inflation

12. If inflation is positive, then the real interest rate is lower than the nominal
interest rate.
If we have deflation and the inflation rate is negative, then the real interest
rate will be larger.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

13. Let us see the formula of the Current Account Balance (CAB)
CAB = X - M + NI + NCT
X = Exports of goods and services
M = Imports of goods and services
NI = Net income abroad [Salaries paid or received,
credit / debit of income from
FII & FDI etc. ]
NCT = Net current transfers [Workers' Remittances
(unilateral), Donations,
Aids & Grants, Official,
Assistance and Pensions etc]
CURRENT ACCOUNT DEFICIT
Hope you have understood the
difference between Real and
Nominal Interest Rate.
REAL INTEREST RATE VS. NOMINAL INTEREST RATE

14. Please give us
your feedback at
professor@tataamc.com

15. DISCLAIMER
The views expressed in this lesson are for information purposes only and do not construe to be
any investment, legal or taxation advice. The lesson is a conceptual representation and may not
include several nuances that are associated and vital. The purpose of this lesson is to clarify the
basics of the concept so that readers at large can relate and thereby take more interest in the
product / concept. In a nutshell, Professor Simply Simple lessons should be seen from the
perspective of it being a primer on financial concepts. The contents are topical in nature and
held true at the time of creation of the lesson. This is not indicative of future market trends, nor
is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this
material will be at your own risk. Tata Asset Management Ltd. will not be liable for the
consequences of such action.
Mutual Fund investments are subject to market risks, read all
scheme related documents carefully.