Final answer:
The interest rate is what lenders charge borrowers, with the nominal rate being the stated rate and the real rate being the nominal rate adjusted for inflation. Inflation and loan riskiness both influence the nominal interest rate; as either increases, nominal rates often do as well to compensate lenders for reduced purchasing power and increased risk.
Step-by-step explanation:
The interest rate is the percentage charged on the total amount of borrowed money. The nominal interest rate is the stated rate without adjustment for inflation. Real interest rate is calculated by subtracting the rate of inflation from the nominal interest rate. For example, a 7% nominal interest rate with 3% inflation means the real interest rate is effectively 4%. Conversely, if there is a deflation of 2%, the real interest rate would increase to 9%. Such unexpected deflation can enhance real interest payments, leading to higher default rates on loans and potential banking sector distress. This situation may decrease aggregate demand and trigger economic recession.
Influence of Inflation and Risk on Nominal Interest Rates
Inflation directly affects nominal interest rates. If inflation is expected to be high, lenders will demand higher nominal interest rates to maintain their purchasing power over the term of the loan. Similarly, the riskiness of a loan influences the interest rate; high-risk loans typically come with higher interest rates because lenders require compensation for the increased risk of default.