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What Is the Connection between Nominal Interest Rate and Inflation?

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  • Written By: Osmand Vitez
  • Edited By: PJP Schroeder
  • Last Modified Date: 03 December 2016
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The nominal interest rate and inflation are two very important figures that help a nation determine the purchasing power of its currency. The nominal interest rate — also called the market rate — is an unadjusted number that often relates to cash deposits or credit. Inflation erodes this rate as the money earned in a savings account or credit loans is less in spending terms. For example, the nominal interest rate and inflation in an economy are five percent and three percent, respectively. The real interest rate in the economy is then two percent as the nominal rate less inflation is the standard formula here.

In a free market economy, the market sets the interest rates. Part of this rate comes from consumer demand, and the other comes from competition, though many factors can have an effect on the rate. Financial institutions offer rates for savings accounts and credit options that are both attractive and will yield money to the institution. Therefore, these rates are nominal as they are set based on various factors. The nominal interest rate and inflation may impact a bank’s earnings for a specific time period.

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Inflation carries the classic definition of too many dollars chasing too few goods. Free market cycles that have little government interaction tend to have some natural inflation. This occurs from growth and more individuals having the ability to purchase goods and services. Unnatural inflation occurs when a government entity attempts to set market interest rates or adjusts the supply of money in an economy. The nominal interest rate and inflation in this market are typically more volatile as the government adjusts the nominal rate to control inflation.

The theory behind these two economic situations is somewhat similar between savings accounts and credit. For savings accounts, the longer the duration of the deposits, the higher the nominal interest rate. This is also the case for available credit options in terms of lending from financial institutions. When this occurs, higher amounts of deposits in savings accounts will result. Investments, savings accounts, and other securities will have different rates due to the risk of the item in the market, with lower rates for higher-quality securities.

Economists study various indices when reviewing the nominal interest rate and inflation over time. The information is also public, so consumers can have an idea on the strength of the economy. Increasing inflation and lower purchasing power typically retards investments made into savings accounts and securities. This is often an important factor in these economic studies.

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