Understanding Nominal Interest Rates

Understanding Nominal Interest Rates Nominal interest rates are the rates advertised for investments or loans that do not factor in the rate of inflation. The primary difference between nominal interest rates and real interest rates is, in fact, simply whether or not they factor in the rate of inflation in any given market economy. It is, therefore, possible to have a nominal interest rate of zero or even a negative number if the rate of inflation is equal to or less than the interest rate of the loan or investment; a zero nominal interest rate occurs when the  interest rate  is the same as the inflation rate - if inflation is 4% then interest rates are 4%. Economists have a variety of explanations for what causes a zero interest rate to occur, including whats known as a liquidity trap, which predictions of market stimulus fail, resulting in an economic recession because of consumers and investors hesitation to let go of liquidated capital (cash in hand). Zero Nominal Interest Rates   If you lent or borrowed for a year at a zero real interest rate, you would be exactly back where you started at the end of the year. I loan $100 to someone, I get back $104, but now what cost $100 before costs $104 now, so Im no better off. Typically nominal interest rates are positive, so people have some incentive to lend money. During a recession, however, central banks tend to lower nominal interest rates in order to spur investment in machinery, land, factories, and the like. In this scenario, if they cut interest rates too quickly, they can start to approach the level of inflation, which will  often arise when interest rates are cut since these cuts have a stimulative effect on the economy. A rush of money flowing into and out of a system could flood its gains and result in net losses for lenders when the market inevitably stabilizes. What Causes a Zero Nominal Interest Rate? According to some economists, a zero nominal interest rate can be caused by a liquidity trap: The Liquidity trap is a Keynesian idea; when expected returns from investments in securities or real plant and equipment are low, investment falls, a recession begins, and cash holdings in banks rise; people and businesses then continue to hold cash because they expect spending and investment to be low - this is a self-fulfilling trap. There is a way we can avoid the liquidity trap and, for real interest rates to be negative, even if nominal interest rates are still positive - it occurs if investors believe currency will rise in the future.​ Suppose the nominal interest rate on a bond in Norway is 4%, but inflation in that country is 6%. That sounds like a bad deal for a Norwegian investor because by buying the bond their future real purchasing power would decline. However, if an American investor and thinks the Norwegian krone is going to increase 10% over the U.S. dollar, then buying these bonds is a good deal. As you might expect this is more of a theoretic possibility that something that occurs regularly in the real world. However, it did take place in Switzerland in the late 1970s, where investors bought negative nominal interest rate bonds because of the strength of the Swiss franc.