Nominal rate

Definition

The nominal rate is the interest rate before adjustments for inflation or other factors. It is often used in exponential growth calculations where interest compounds over time.

5 Must Know Facts For Your Next Test

1. The nominal rate does not account for the effects of inflation, making it different from the real interest rate.
2. In exponential functions, the nominal rate is critical in calculating compound interest.
3. Nominal rates are usually expressed on an annual basis but can be converted to different compounding periods.
4. The formula for compound interest using the nominal rate is $A = P(1 + \frac{r}{n})^{nt}$, where $P$ is the principal amount, $r$ is the nominal annual interest rate, $n$ is the number of times interest is compounded per year, and $t$ is the time in years.
5. Understanding how to convert a nominal rate to an effective annual rate (EAR) involves recognizing that EAR accounts for compounding within the year.

Review Questions

• What distinguishes a nominal rate from a real interest rate?
• How do you use a nominal rate in calculating compound interest?
• Explain how to convert a nominal annual interest rate into an effective annual rate.

Related terms

Compound Interest: Interest calculated on both the initial principal and the accumulated interest from previous periods.

Effective Annual Rate (EAR): The annual return on an investment when compounding occurs more than once per year.

Exponential Growth: \text{Growth whose rate becomes ever more rapid in proportion to the growing total number or size.}