Distinguish real and normal interest rate (3Marks)?

Real interest rate refers to the interest rate adjusted for inflation, while normal interest rate refers to the prevailing interest rate in the market.

Real interest rate takes into account the purchasing power of money, as inflation erodes the value of money over time. Normal interest rate, on the other hand, is the rate at which borrowers can borrow money and lenders can lend money in the market.

Real interest rate is a more accurate measure of the true cost of borrowing or the return on investment, as it reflects the actual increase in purchasing power. Normal interest rate, on the other hand, is influenced by various factors such as central bank policies, market conditions, and economic indicators.

In summary, real interest rate adjusts for inflation, while normal interest rate is the prevailing rate in the market.

Real Interest Rate (i)

- Adjusts for the effects of inflation.
- Measures the true cost of borrowing or earning money in terms of purchasing power.
- Calculated as the nominal interest rate (r) minus the inflation rate (π): i = r - π

Nominal Interest Rate (r)

- The stated or quoted interest rate charged or paid for a loan or financial instrument.
- Unadjusted for inflation.
- Can be misleading if inflation is present, as it may overstate or understate the actual cost or return.

Relationship between Real and Nominal Interest Rates

- In the presence of inflation (π > 0):
- Real interest rate is lower than the nominal interest rate: i < r
- In the absence of inflation (π = 0):
- Real interest rate and nominal interest rate are equal: i = r
- In deflation (π < 0):
- Real interest rate is higher than the nominal interest rate: i > r

Importance of Real Interest Rates

- True measure of the cost of borrowing or return on savings.
- Helps investors make informed decisions about investments and savings strategies.
- Used by central banks to manage inflation and economic growth.

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