Inflation and the interest rate
Since interest is considered the price for borrowed funds, it changes with the change in the value of money. This happens at the time of inflation. The nominal rate of interest is the interest rate that is visible to the customers with no adjustments made with regard to the inflation rate. Hence the mathematical formula used for the calculation of the real rate of interest is given as follows:
i= r+? where i: nominal rate of interest
r: real rate of interest
?: Inflation rate
This above formula is criticised on two grounds:
The interest rate would be the same for all places that have the same inflation rate.
The lender is only aware of the prevailing inflation rate , not the expected rate of inflation
This problem of information asymmetry is well tackled with the help of the following formula:
it = rt+1 + ?t+1 + ?
where it : nominal interest rate corresponding to the time when the loan is taken
rt+1 : expected real rate of interest over the loan tenure
?t+1 : Expected inflation rate over the loan tenure
? : Level of risk involved