An interest rate is the 'rental' price of money.
When a resource is borrowed, the borrower pays the lender for the
use of the resource. The interest rate is the price paid for the
use of money for a period of time. When money is loaned the lender
defers consumption (or use of the money) for a specific period of
time. The lender does this in exchange for an increase in consumption.
The increase in consumption expected is the real interest rate.
The increase in consumption, however, is diluted by the effect of
inflation. Thus the actual rate charged (known as the nominal rate)
has to take inflation into account. Quite simply the nominal rate
rn = rr + i
rn = nominal interest rate
rr = real interest rate
i = projected inflation
Other approximations for the nominal interest rate exist.
rn = rr + i + d + mrp + lp
d = default premium (likelihood of default by the borrower)
mrp = maturity risk premium (risk factor for length of borrowing period)
lp = liquidity premium
Irving Fisher proposed a better approximation of the relationship
between nominal interest rate, inflation and real interest rate.
(1 + rn) = (1 + i)(1 + rr)
For example: assume the real rate desired is 2% but inflation is running
at 5%. Then the lender will charge:
(1 + .05)(1 + .02) = 7.1%