David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 11 Factor markets and income distribution
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Nominal interest
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Figure 11.2
Nominal interest rate ond inflation rote in UK: monthly overages
Sources: Bank of England and ONS.
Equation (2) is known as the Fisher equation. 1 It implies that the nominal interest rate can be written as
the sum of the real interest rate and the inflation rate. Therefore, for a given real interest rate inflation and
nominal interest rate should move together. This is shown in Figure 11.2, where we plot the nominal
interest rate (as measured by the monthly average official bank rate) and the monthly inflation rate
(measured by the change in the retail price index) in the UK.
What determines the real interest rate?
Two forces lead to positive real interest rates. First, people are impatient. Given the choice of an equal
number of goods tomorrow or today, we'd rather have them today. To delay spending on goods and services,
savers have to be bribed with a positive real interest rate that lets them consume more goods in the future
if they postpone consumption and lend today.
Second, there must be a way of earning positive real returns, or borrowers would never borrow. Borrowers
pay positive real interest rates because they can buy capital goods that provide a stream of returns more
than sufficient to meet the interest cost.
Impatience to consume and the productivity of physical capital are the two forces that lead us to expect a
positive real interest rate. Real interest rates are usually small and positive. Since real interest rates change
little, big changes in nominal interest rates usually occur to offset big changes in inflation rates, keeping
real interest rates in their normal range, determined by the forces of impatience and capital productivity.
A good rule of thumb is that each percentage point rise in inflation is matched by a percentage point rise
in nominal interest rates, leaving real interest rates the same as before.
To calculate present values, we must be consistent. If we wish to calculate the present value of a future
payment expressed in nominal terms, we must discount by the nominal interest rate. If the future payment
is expressed in real terms, we must discount using the real interest rate.
1 From Irving Fisher, the economist who first pointed out that relationship between nominal and real interest rates.
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