What Is Nominal Interest Rate?

Understanding Nominal Interest Rate

Central banks set short-term nominal interest rates, which form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels after a major recession to stimulate economic activity through low real interest rates, which encourage consumers to take out loans and spend money. However, a necessary condition for such stimulus measures is that inflation should not be a present or a near-term threat. In the United States, the federal funds rate, the interest rate set by the Federal Reserve, can also be referred to as a nominal rate.

Conversely, during inflationary times, central banks tend to set nominal rates high. Unfortunately, they may overestimate the inflation level and keep nominal interest rates too high. The resulting elevated level of interest rates may have serious economic repercussions, as they tend to stall spending. Nominal interest rates exist in contrast to real interest rates and effective interest rates. Real interest rates tend to be important to investors and lenders, while effective rates are significant for borrowers as well as investors and lenders.

Although the nominal rate is the stated rate associated with a loan, it is typically not the rate that the consumer pays. Rather, the consumer pays an effective rate that varies based on fees and the effect of compounding. To that end, annual percentage rate (APR) differs from the nominal rate, as it takes fees into account, and annual percentage yield (APY) takes both fees and compounding into account.