4.2 — Nominal vs. Real Interest Rates

The Fisher Formula shows us the relationship between real and nominal interest rates. While there is an exact fisher formula, we use an approximate version which is as follows: $i\approx r+\pi$ where:

• $i$ which represents the nominal interest rate (not adjusted for inflation)
• $r$ which represents the real interest rate (adjusted for inflation)
• $\pi$ which represents the interest rate, as measured by the CPI and GDP Deflator

Expected vs Actual Inflation

If we manipulate Fisher’s Formula, we see how the actual inflation rate impacts the real rate of inflation. Since $i-\pi \approx r$, an increase in the actual interest rate will correspondingly decrease the real interest rate.

As a result, higher than expected inflation helps borrowers and hurts lenders as borrowers will pay back with lower real interest, which means the money paid back will be less valuable. Conversely, lower than expected inflation will hurt borrows and help lenders as borrowers will pay back with higher real interest, which means the money paid back will be more valuable.