Real vs. nominal interest rate | Banking | Financial Literacy | Khan Academy

Let's think about two different scenarios and decide which one is a better world for us.

So, there is scenario one where, lucky day, we got a raise at work. We are now making 3% more than we used to make. That sounds good, but there's a little bit of a tricky thing going on here: the cost of things has also increased in the world. So, we have inflation is also up by 3%. That's scenario one.

Now, let's think about scenario two. Here in scenario two, we get a raise of 2%, and inflation in scenario two is 1%. Pause this video and think about what's a better world for you and which world are you actually able to buy more stuff.

Alright, well, let's think about it. Just to simplify things, imagine if you were making, let's say, $1,000 a week before. Now, that is going, if you increase that by 3%, that increases to $1,030 per week. Now, just to make it simple, let's just imagine that the amount that you were bringing in is also the amount that you were spending. So, before, you were bringing in $1,000, and you were spending $1,000.

Now you're bringing in $1,030, but because inflation has increased by 3%, you're also going to have to spend 3% more. So, you're also spending $1,030. It's not like you're going to be saving that extra $30. So, your world really hasn't changed at all over here.

While over here, let's imagine this world where you start with that $1,000 that you were making, and then after the 2% raise, you are earning, I should say, $1,020 a week. But how much are you spending? Well, if you were spending $1,000 before and now you're spending 1% more than that, you are now spending $1,010 a week. So, you are $10 a week better off than you were before.

Even though your raise is smaller in this scenario, inflation is even smaller than the raise. So, you might be wondering if there is a word to think about how much you are really growing in terms of your purchasing power. That word definitely exists, and it's called the real interest rate.

The real interest rate. There’s a slightly more complicated formula if you really want to calculate it precisely that you can find on Khan Academy, but for just estimation purposes — and it suits most of our purposes — you can think of estimating it as the interest rate, or you could say the nominal interest rate. Sometimes people would say nominal.

Nominal interest rate is just how much is the thing growing minus the rate of inflation. So, in this first scenario right over here, the real interest rate, what would it be? Well, if we're estimating it, it would be 3% minus 3%. So, I would say it's approximately 0% here. Actually, in this scenario, even if you use the complicated formula, it actually is 0%. So, this is a 0% real interest rate.

While over here, if I were to approximate it, I would say 2% minus 1% which is 1%. So, I'm roughly growing 1% in the amount of purchasing power I have. This is a really useful thing to think about in terms of your personal finances.