Explanation:

The nominal interest rate is the simplest type of interest rate. It is the stated interest rate of a given bond or loan. The nominal interest rate is in the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them. But nominal interest rate doesn’t take inflation into account.

A real interest rate is the interest rate that does take inflation into account. As opposed to the nominal interest rate, the real interest rate adjusts for the inflation and gives the real rate of a bond or a loan.

Now imagine that the inflation rate was 5%. A 5% inflation rate means that an average basket of goods you purchased this year is 5% more expensive when compared to last year.

Continuing with our previous example, the lender would make nothing if he loaned it out at 5% when the rate of inflation was 5%.

The approximate formula is Real Interest Rate (R) = Nominal Interest Rate (r) – Rate of Inflation (i)