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Markets - Money marketsFurther work - Inflation expectations and real interest ratesThe real interest rate is approximately equal to the nominal interest rate minus the expected inflation rate. The real interest rate matters because people will typically base their savings and investment decisions on real rather than nominal interest rates if they are behaving rationally. It is only by considering the level of real interest rates that it is possible, even in principle, to assess whether any given nominal interest rate represents a relatively tight or loose monetary policy stance. For example, if expected inflation were 10%, then a nominal interest rate of 10% would represent a real interest rate of zero, whereas if expected inflation were 3%, a nominal interest rate of 10% would imply a real interest rate of 7%. So for given inflation expectations, changes in nominal and real interest rates are equivalent, but if inflation expectations are changing, the distinction becomes important. |
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