Final answer:
Interest rates that include an inflation premium are called nominal rates. They combine the real interest rate with expected inflation, which affects the effective borrowing costs and can lead to various economic implications, such as affecting borrowers' payment burdens and banks' net worth.
Step-by-step explanation:
Interest rates that include an inflation premium are referred to as nominal rates. Nominal interest rates are the advertised rates that include both the real rate of interest and the expected rate of inflation. For instance, if the nominal interest rate is 7% and the rate of inflation is 3%, then the borrower is effectively paying a 4% real interest rate. Conversely, during deflation, if the nominal rate is 7% and deflation is 2%, the real interest rate would be 9%. Such unexpected deflation can lead to increased real interest payments for borrowers, potentially causing widespread defaults that erode banks' net worth and can contribute to a recession.
In contrast to nominal rates, real interest rates reflect the purchasing power of the interest amounts, by subtracting the rate of inflation from the nominal rate. Sometimes, borrowers can benefit from inflation if they have a fixed interest rate and inflation rises, as it lowers the real interest rate they have to pay. However, higher inflation can hurt lenders who receive payments in less valuable dollars, illustrating the risks associated with fixed rates in inflationary contexts.