Real vs. nominal interest rate

0:00- [Instructor] 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 is a little bit of a tricky thing going on here.

0:20The 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, inflation is 1%. Pause this video and think about what's a better world for you?

0:53In which world are you actually able to buy more stuff? All right, well let's think about it. Just to simplify things, imagine if you were making, let's say, $1,000 a week before, and now that is going, if you increase that by 3%, that increases to $1,030 per week.

1:18And now let's, 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 you bring, 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.

1:41It'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 spending a thousand, or you are earning, I should say, $1,020 a week.

2:07But 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 and so you are $10 a week better off than you were before. And so even though your raise is smaller in this scenario two, inflation is even smaller than the raise.

2:35So you might be wondering, "Is there a word to think about how much you are really growing in terms of your purchasing power?" And 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.

2:58But for just estimation purposes, and it suits most of our purposes, you can think of estimating it as the interest rate, interest rate, or you could say the nominal interest rate. Sometimes people would say nominal. Nominal interest rate is just, what are you, how much is the thing growing minus the rate of inflation.

3:25Minus the rate of inflation. So in this first scenario right over here, the real interest 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. And actually in this scenario, even if you use the complicated formula, it actually is 0%, so this is a 0% real interest rate.

3:55While over here, if I were to approximate it, I would say 2% minus 1%, which is 1%. So I'm roughly growing 1% the amount of purchasing power I have. And so this is a really useful thing to think about in terms of your personal finances.