5.4 Nominal and Real Interest Rates

We can also call the interest rates we are using in the introductory chapters nominal interest rates. As you will see shortly, two primary components constitute a nominal interest rate: inflation and the real interest rate. The real interest rate is the reward for waiting. We will talk more about it as we progress through this section. The nominal rate is the percentage change in the actual dollars that you receive on your investment. The real rate is the percentage change in the purchasing power of those dollars. With inflation, they buy less. Let’s see how these rates work.

Assume you are willing to postpone the consumption of $500 today to buy a 7% CD at your local bank. Holding the CD for one year provides ...

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