What are nominal and real interest rates?
From the economic perspective it is important to differentiate between nominal and real interest rates. Nominal interest rates are the rates quoted in loan and deposit agreements. Real interest rates, on the other hand, are obtained by deflating the nominal rates, that is to say, by adjusting them for the decrease in the real value (i.e. purchasing power) of the borrowed or deposited funds over the duration of the loan or deposit. The decrease in the real value of the funds over a given period is equal to the rate of inflation for that period.
When the deflation is carried out after the end of the loan or deposit period, this is known as the ex post approach. Here, the actual decrease in real value over the duration of the loan or deposit is used. In other words, we deflate by the inflation actually measured for that period. Real rates obtained in this way are called "ex post real interest rates". When the deflation is carried out before the end of the loan or deposit period, this is known as the ex ante approach. Here, we are compelled to use the expected decrease in real value, that is, we deflate by the expected rate of inflation for that period. Rates calculated in this way are termed "ex ante interest rates". Economic agents may arrive at various real interest rates for any given nominal rate depending on their inflation expectations or on the measure of inflation they use for deflating.
Provided the nominal interest rate and inflation rate are low, an approximate deflation can be performed by subtracting the actual or expected inflation rate during the loan or deposit period from the nominal interest rate. But to calculate the real interest rate accurately (for any nominal interest rate and any rate of inflation), the following equation is used:
r = [(100 + R)/(100 + i) - 1]*100,
r = real interest rate (in %)
R = nominal interest rate (in %)
i = actual or expected inflation rate (in %)