Nominal Interest rate:
The rate of interest borrower pay to lender for the use of money.
Example: You borrow 1000 rs from bank, at 10% rate of interest for 1 year. After 1 year you will repay 100 rs as interest above 1000 rs borrowed.
This rate of interest does not tell about inflation effect on money received by lender. Hence purchasing power of the money loaned and purchasing power of the money received can differ.
Real Interest rate:
Real Interest rate is inflation adjusted interest rate. It measures the purchasing power increase or decrease in the amount which lender will receive by taking inflation in consideration.
Let us continue with example mentioned. Say, there is 10% inflation in the same year. Lender will earn 10% (Rate of interest) – 10% (Inflation) = 0% is real interest rate.
What effective measure do bank take to tackle inflation effect on it’s lending business?
Banks by looking at Inflation trend, increase or decrease the Nominal rate of interest they charge to customer. This help them save their profit margin and neutralize the inflation effect.
If you observe above example carefully, during inflation time when bank is receiving back money with less purchasing power, paid by borrower, the borrower is also in profit as money purchasing power was higher when she/he took loan (in beginning) compared to what she/he pays.
This bonus to borrower by the inflation is known as Inflation premium.