Real And Nominal Interest Rate

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Suppose we buy a 1 year bond for face value that pays 6% at the end of the year. We pay $100 at the beginning of the year and get $106 at the end of the year. Thus the bond pays an interest rate of 6%. Sponsored Links
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This 6% is the nominal interest rate, as we have not accounted for inflation. Whenever people speak of the interest rate they're talking about the nominal interest rate, unless they state otherwise.
Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it will cost $100, or we can buy that basket next year and it will cost $103. If we buy the bond with a 6% nominal interest rate for $100, sell it after a year and get $106, buy a basket of goods for $103, we will have $3 left over. So after factoring in inflation, our $100 bond will earn us $3 in income; a real interest rate of 3%. The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher Equation:

Real Interest Rate = Nominal Interest Rate - Inflation
If inflation is positive, which it generally is, 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.
2. Nominal GDP Growth vs. Real GDP Growth
GDP, or Gross Domestic Product is the value of all the goods and services produced in a country. The Nominal Gross Domestic Product measures the value of all the goods and services produced expressed in current prices. On the other hand, Real Gross Domestic Product measures the value of all the goods and services produced expressed in the prices of some base year. An example:
Suppose in the year 2000, the economy of a country produced $100 billion worth of goods and servi...