What characterizes a nominal interest rate?

A nominal interest rate is characterized as one that includes the impact of inflation on the cash flows. This means that when you see a nominal interest rate, it reflects the overall cost of borrowing or the return on investment without adjusting for changes in purchasing power due to inflation.

When inflation rises, the actual purchasing power of money decreases over time, and nominal interest rates are set to compensate for this loss. Therefore, nominal rates provide borrowers and investors with a measure that accounts for inflationary effects, making them essential for understanding the effective cost of loans or the real yield on investments.

Understanding this distinction is crucial, especially when evaluating the performance of investments or the cost of financing in an inflationary environment. It clarifies how nominal rates differ from real interest rates, which adjust for inflation and provide insight into the actual increase in purchasing power.