So far in this section, we have been considering nominal interest rates, but we know that the decisions of firms and households are based on real interest rates. The link between nominal and real interest rates is given by the Fisher equation:
real interest rate ≈ nominal interest rate − inflation rate.
To use this relationship, we simply subtract the inflation rate from the nominal interest rate. So if the nominal interest rate were 15 percent, as it was in the early 1980s, and the inflation rate were 12 percent, then the real interest rate would be 3 percent. But if the inflation rate were higher—say, 18 percent—then the real interest rate would be minus 3 percent.
Toolkit: Section 16.14 "The Fisher Equation: Nominal and Real Interest Rates"
The toolkit reviews the derivation of the Fisher equation.
***Figure 10.5 "Real and Nominal Interest Rates" shows the nominal and real rates of return for a one-year Treasury bond. Because inflation is positive, the nominal interest rate exceeds the real rate. The figure shows that the nominal and real rates typically move closely together. In the early 1980s, for example, the real interest rate was negative. Presumably when households lent money in the early 1980s, they did not expect a negative return on their saving but instead expected that the nominal interest rate would exceed the inflation rate. From that perspective, the negative real interest rate is a consequence of higher than anticipated inflation.
The Fed’s ability to influence longer-term nominal rates through its influence on the federal funds rate apparently extends to the real interest rate as well. The connection is not perfect, however. On some occasions, movements in nominal rates are decoupled from movements in real rates.
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