How is a Nominal Interest Rate Chosen

Interest rates, when posted almost anywhere, are stated in nominal terms. Nominal (versus real) is a simple way of expressing interest rates. If the nominal rate listed says 6%, that means I can borrow a dollar at that rate, and in a year pay back $1.06. This overlooks an decrease in purchasing power that money has experienced over that period of time, also referred to as inflation. The real rate of interest would be, essentially, the inflation rate over a given period minus the nominal interest rate. Being that companies who are lending money do not, on any sort of real basis, know what inflation will be over an extend period of time, how do they determine the interest rate that they need to charge a customer to achieve a desired real rate of return?

The equation we can look at to do this is called the fisher effect. The fisher effect, expressed mathematically is:

1+r= (1+a)(1+i) or closely approximated with r = a + i

where r is the nominal rate, a is the expected inflation and I is the real interest rate desired.

In very simple terms this gives the institution the rate that they need to charge. If predictions say that inflation over the next year will be 6% and the institution has determined that it needs to receive a real interest rate of 4% for the loan to be a viable source of income. We can then plug those numbers into the fisher effect equation and determine the nominal rate that will need to be charged.

In the above example r is the variable we are seeking, a = 4% and I = 6%.

So r=4%+6% or r = 10%.

Using the shorter, approximate, equation we can see that in the above example the firm would theoretically need to charge a nominal rate of 10% if it expects to obtain it's desired real rate of return of 4%.

The fisher effect goes beyond this to give a detailed analysis of how equilibrium interest rates are reached internationally. These equilibrium rates are based largely on fluctuations in the individual economies involved and hence the relative values of their currencies. This more complex portion of the fisher effect will be covered in an upcoming article. Please check out my publications page.