Real vs Nominal Interest

The fact that changes in the rate of interest brought about by the central bank of any nation will have significant consequences on the real and monetary variables of the economy is hardly unexpected or in any way surprisingly stunning a conclusion. Generally, the central bank changes the interest rate as a part of its inflation-targeting monetary policy package. As a direct result of this rise in interest rate, commercial banks find borrowing from the central bank to be more costly now and thus overall lending outfalls and the pace of the price movements slow down as there is a decline in overall spending.The first step, in identifying these channels and more importantly perceiving the mechanism through which they work, is distinguishing between real and nominal interest rates and clarifying how changes in nominal interest rates affect the real interest rate. The nominal interest rate refers to solely the monetary value of the price of borrowing funds while the real interest rate refers to the effective cost of borrowing which incorporates the rate of inflation along with the nominal interest rate. So, we have the relation:Generally, the rate of interest refers to the nominal rate unless specifically mentioned. Thus, when we discuss the effects of changes in the interest rate by the central bank we are talking about the impacts of a change in the nominal rate of interest.The impact of a change in the interest rates can be very lucidly explained in terms of the substitution, income, and wealth effects generated through interest rate movements. An increase (decrease) in the rate of interest (nominal or real) reduces (raises) the relative attractiveness of spending now as opposed to in the future for economic agents. So, the nominal variables domestic credit, the quantity of domestic money as well as real demand all fall (rise). This is referred to as the substitution effect.