If you lend me $100 and i offer to pay you a return of 7% at the end of one year, youllbe left with $107. in this case the nominal rate of interest i paid you was 7%.however, lets assume over the same one-year time frame that a basket of goods thatcost you $100 at the start of the year now costs you $104 at the end of the year. inother words, inflation for the year was 4%.question: did you realize a rate of return of 7% on your investment? the nominal ratewould indicate that you did. but heres the problem. at year end, you take your $107and buy the basket of goods that was $100 but is now $104. you are left with $3 afteryou spend your money. ideally, you would have liked to have $7 left over - after all,thats what your investment was earning. but instead, you are left with $3.in this scenario, 7% is the nominal interest rate. the inflation rate is 4%. becauseinflation ate away at your return, your real return was only 3% (i.e., the real interestrate is 3%).
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