What do we understand by Interest Rate?

Let us imagine for a moment that we have won two prizes worth 10,000 $ each, but we can only choose one of them, if we accept one we cannot claim the other one. The first prize is redeemable today, the second one is redeemable in 2 years. Which one should we choose? It seems evident that we will choose the one we can claim today since the money seems to be worth more today than in a couple of years. Now, let us suppose that in turn, in two years, the second prize is redeemable with an added bonus of 5,000 $ as a reward for our waiting. Which prize would we choose then? In this case we would probably still choose the first prize if we really were short in cash. That reward of 5,000 $ given for waiting is what is called interest rate and it is equivalent to the value given to money overtime. In other words, if we feel indifferent about having 10,000 $ now and 15,000 $ it is because we feel that it will have the same purchasing power.

It is also noted that the interest rate is billed over a determined sum of money. In that way, for example, its value could be the half, sixth part, fifth part, tenth part or any fraction of the initial amount. If our initial amount is 100 and it is said that our interest rate is the tenth part of the initial sum, that would mean we have a 10% interest rate, and if it would have been the half, we would be talking about a 50% interest rate.

What is nominal interest rate?

This is the kind of interest rate which is often talked about, the one we often hear people talking about. The nominal interest rate is the interest rate in actual to-day prices.

What is the real interest rate?

As we mentioned earlier, the interest rate represents a reward for postponing our present consumption with the intent of receiving more money in the future. When said reward is expressed in the quantity of goods and services we can buy with it that is what we call real interest rate. Better said, it is the interest rate resulting from considering the effects of inflation, which diminish the value of our earned interest rate. Most formally we could say:

Real Interest Rate = Nominal Interest Rate – Inflation

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