Mortgage rates and other interest rates are based on underlying dollar amounts; the interest rate tells you how many dollars borrowers must pay to lenders for each dollar that they borrow. Because they are based on dollar amounts, they are called nominal interest rates. When you see a mortgage rate quoted by a bank or a rate on a credit card, it is a nominal rate.
The nominal rate does not tell us the true cost of borrowing, or return on lending, when there is inflation in an economy. For example, suppose that the nominal interest rate is 5 percent, but inflation is also 5 percent. If you took out a $1,000 loan, you would have to pay back $1,050 next year. But that $1,050 would buy exactly the same amount of real gross domestic product (real GDP) next year as $1,000 does this year—that is what it means to have 5 percent inflation. So, in terms of actual goods and services, you have to pay back the same amount that you borrowed. The real interest rate—that is, the interest rate corrected for inflation—is zero.
Toolkit: Section 16.5 "Correcting for Inflation"
The Fisher equation is a formula for converting from nominal interest rates to real interest rates, as follows:
real interest rate ≈ nominal interest rate − inflation rate.
The real interest rate gives the true cost of borrowing and lending; it is the real interest rate that actually matters for the decisions of savers and borrowers. [***We derive the Fisher equation more fully in Chapter 9 "Money: A User’s Guide".***] That doesn’t mean, by the way, that our previous two diagrams were incorrect because they used the nominal interest rate. Provided that the inflation rate doesn’t change, a comparative static exercise using the nominal interest rate will give you exactly the same conclusion as one using the real interest rate.
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