How do nominal interest rates differ from real interest rates?

Nominal interest rates represent the stated interest rates on loans or financial products without any adjustment for inflation. This means that when you hear about an interest rate of, for example, 5%, this rate is nominal and does not take into account how inflation affects the purchasing power of that money over time.

In contrast, real interest rates are adjusted for inflation and reflect the true cost of borrowing and the real yield to investors. The real interest rate can be calculated by subtracting the expected inflation rate from the nominal interest rate. This gives borrowers and investors a clearer understanding of how much value they are gaining or losing in terms of purchasing power.

The option stating that nominal rates do not adjust for inflation, while real rates do, correctly highlights this fundamental distinction. Understanding this difference is essential, especially when making financial decisions, as it helps individuals assess the true cost of borrowing and the return on their investments relative to inflation.