Introduction

Chapter 11 explores the concepts of nominal and real interest rates, which are essential components in understanding the relationship between interest rates and exchange rates. Interest rates play a crucial role in financial markets and impact investment decisions, inflation expectations, and exchange rate movements. Understanding the distinction between nominal and real interest rates is vital for investors and policymakers alike. This chapter will delve into the definitions, calculations, and implications of nominal and real interest rates, shedding light on their significance in the context of foreign exchange markets.

Nominal Interest Rate

The nominal interest rate refers to the stated interest rate on an investment or loan without considering the impact of inflation. It represents the rate at which an investment grows or a loan accumulates interest over time. In a nominal interest rate, the effects of inflation are not factored in, making it an apparent or nominal return.

Formula for Calculating Nominal Interest Rate:

$$\text{Nominal Interest Rate = } \left( \dfrac{\text{Interest Paid}}{ \text{Principal}} \right) \times 100$$

Example: Suppose an individual invests USD 10,000 in a bank account that pays 5% interest annually. The nominal interest rate in this case would be:

$$\text{Nominal Interest Rate = } \left( \dfrac{5 \% \times \text{USD 10,000}}{ \text{USD 10,000 }} \right) \times 100 = 5 \%$$

Real Interest Rate

The real interest rate, on the other hand, accounts for inflation and reflects the actual purchasing power gained or lost on an investment or loan. It represents the adjusted rate after considering the inflationary effect on the investment or loan’s nominal return.

Formula for Calculating Real Interest Rate:

$$\text{Real Interest Rate = } \left[ \dfrac{(\text{1 + Nominal Interest Rate}) }{(\text{1 + Inflation Rate}) } \right]-1$$

Example:

Suppose the nominal interest rate on a loan is 8%, and the inflation rate is estimated to be 3%. The real interest rate would be:

$$\text{Real Interest Rate = } \left[ \dfrac{(1 + 8 \%) }{(1 + 3 \%) } \right]-1 = 4.85 \%$$

Significance of Nominal and Real Interest Rates in Foreign Exchange Markets

In foreign exchange markets, nominal and real interest rates are essential factors influencing exchange rate movements. Higher nominal interest rates may attract foreign investors seeking better returns on their investments, increasing the demand for the domestic currency and leading to its appreciation. However, this appreciation may be offset if the inflation rate is significantly higher, resulting in a lower real interest rate and potentially discouraging foreign investments.