Final answer:
The nominal rate of interest is made up of the real rate of interest and compensation for inflation; thus, the correct answer is D) both A and B. It is the rate before inflation adjustment, and it is crucial to understand its components for actual financial returns.
Step-by-step explanation:
The nominal interest rate is the interest rate before taking inflation into account, and it serves as the stated rate on a loan. When lending or investing, the real interest rate is what matters to investors and lenders, as it represents the purchasing power of the interest payments they receive. The real interest rate is calculated by adjusting the nominal rate to remove the effects of inflation. For example, if the nominal rate is 7% and inflation is 3%, the real rate would be 4%. Conversely, if there is deflation of 2%, the real interest rate would be 9%. Unexpected inflation or deflation can significantly affect the real returns for lenders and the cost of borrowing for borrowers.
The nominal rate of interest is made up of the real rate of interest and compensation for inflation. The real interest rate is the nominal interest rate minus the rate of inflation. This means that the nominal interest rate includes both the base rate of interest and the adjustment for inflation. For example, 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.