Nominal interest rates and inflation affect a nation’s currency purchasing power. Inflation erodes the nominal rate, and the real interest rate is calculated by subtracting inflation from the nominal rate. In a free market economy, interest rates are set by the market, and financial institutions offer nominal rates based on various factors. Unnatural inflation occurs when a government entity attempts to set market interest rates or adjust the money supply in an economy. Economists study various indices by looking at the nominal interest rate and inflation over time.
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 often associated with cash or credit deposits. Inflation erodes this rate as money earned in a savings account or credit loan is less in terms of spending. 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, since the nominal rate minus inflation is the standard formula here.
In a free market economy, the market sets interest rates. Part of this rate comes from consumer demand, and the other comes from competition, although many factors can have an effect on the rate. Financial institutions offer rates for savings accounts and credit options that are attractive and will generate money for the institution. Therefore, these rates are nominal since they are established based on various factors. The nominal interest rate and inflation can affect a bank’s earnings for a specific period of time.
Inflation carries the classic definition of too many dollars chasing too few goods. Free market cycles that have little government interaction tend to have natural inflation. This is happening because of growth and more people having the ability to buy goods and services. Unnatural inflation occurs when a government entity attempts to set market interest rates or adjust the money supply 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 and credit accounts. For savings accounts, the longer the duration of the deposits, the higher the nominal interest rate. This is also the case with the credit options available in terms of loans from financial institutions. When this occurs, larger amounts of savings account deposits will be generated. 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 by looking at the nominal interest rate and inflation over time. The information is also public, so consumers can get an idea about the strength of the economy. Rising inflation and lower purchasing power generally delay investments made in savings and securities accounts. This is often an important factor in these economic studies.
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