Conversely, if the inflation rate was to increase at the same rate as the nominal interest rate, the real interest rate would remain constant. The below equation shows the relationship between nominal interest rate, real interest rate, and inflation;

(1 + i) = (1 + R) (1 + h)

Where

h - Expected inflation rate
R - Real interest rate
I – Nominal interest rate

Nominal interest rate =( (1+Interest rate)*(1 + inflation rate))-1

For instance, assuming the real rate of interest is 3% and rate of inflation is 2%, the nominal rate of interest would be calculated as follows;

((1+3%)*(1+2%)) – 1 = 5.06%

Many central banks set short-term low nominal interest rates as a monetary tool to encourage consumers to borrow and spur economic growth. In this respect, central banks can raise the nominal interest during an economic recession and increase it during an inflationary period, as the case may be.

Effective Interest Rate

Effective interest rate, also known as annual equivalent rate, is the actual interest rate paid on loan or earned on investment when the compounding effect is taken into account. In most cases, the effective interest rate is higher than the nominal interest rate. It is a good way of comparing the costs of different financial products.

Different financial institutions compound annual interest rates over different periods – weekly, monthly, or annually. The effective interest rate changes depending on the number of times it compounded over a given period. As we will see, the effective annual interest rate increases as the number of compounding periods increases.

Effective interest rate is derived from the stated interest rate, or nominal interest rate, and its formula is given as follows;

Why Should You Distinguish Between Nominal and Effective Interest Rate?

While the nominal interest rate is a stated interest rate that works as a simple interest, effective interest rate factors compounding periods the interest is subjected to. As an investor or borrower, you need to distinguish the two so that you can make informed financial decisions.

Many financial institutions can take advantage of borrowers and mislead them. As a borrower, it is good to clearly understand the terms of the loan so that you can be in a position to honor payments obligations. If you are an investor, you would need to understand the expected return of your investment.

This would assist you in gauging the attractiveness of an investment. An investment can promise a higher return on the surface, but when you look deeper into the applicable effective interest rate, it turns out to be less attractive. You could also overlook an otherwise attractive investment because it promises lower interest rates on the surface.

Many companies also use the effective interest rate to ascertain actual return on investment and interest expense on loans. For example, a high effective interest rate on loan would translate into a high-interest coverage ratio that would affect your company's ability to service the debt. Investors will stand to benefit if the effective rate is higher than the nominal rate on the flip side.

As we stated earlier, nominal interest rates do not account for the inflation rate. Even as you base your decisions on the effective interest rate, don’t forget other factors you need to bring into the picture. You can factor the expected inflation rate in your decision-making process, especially if it is a long term arrangement, so as you cushion yourself against high inflation rate

Factors affecting Nominal and Effective Interest Rates

Money supply and demand affect nominal interest rates. There is an inverse relationship between nominal interest rate and money supply in an economy. Interest rates keep on changing depending on the prevailing market condition. As an investor or borrower, you need to understand the dynamics so that you can plan well.

1. Money Supply

At a macro level, there is an inverse relationship between money supply and nominal interest rate. As the demand for money goes up, interest rates tend to decline. Many governments use the two as a monetary tool for regulating economic activities. During an economic recession, central banks tend to lower the nominal interest rates to spur economic growth. Conversely, they increase nominal interest rates during an inflationary period.

2. Government Borrowing and Fiscal Deficit

Governments may borrow money from the bond market if they have a fiscal deficit. The higher the government's deficit, the more it will borrow and the higher the demand for money. This will increase the interest rates.

3. Inflation rate

At a macroeconomic level, the inflation rate moves in the opposite direction as nominal interest rates. Governments tend to influence the inflation rate by adjusting the altering the existing interest rates. They can set a benchmark rate that commercial banks use to set their interest rates in effect.

If a government sees the need to increase the spending rate or lower inflationary pressure, it reduces interest rates so people can borrow at lower interests. This increases consumers' purchasing power.

4. Global foreign Exchange Rates and Interest Rates

Countries are always looking for ways to encourage direct foreign investment. One of the ways they can do this is by use of interest rates. Increasing interest rates attract foreign investors and thus high foreign direct investments. Demand for the local currency tends to increase as interest rates increase due to high capital investments from foreign investors.

5. International Fisher Effect

In an ideal situation nominal rate of interest is supposed to reflect the expected Inflation Rate and the real rate of return. For instance, if the current real rate of return is 4.5% and the expected inflation rate is 5.5%, then the appropriate nominal rate of interest should be 10%. This is, however, a lot of controversies surrounding the theory. Commercial banks determine the effective interest rates, but they base it on the current nominal interest rate. In most cases, they are positively correlated.