updated on May 15th, 2019
- The bonus brought by inflation to the borrowers is known as the inflation premium.
- The interest banks charge on their lending is known as the nominal interest rate, which might not be the real cost of borrowing paid by the borrower to the banks.
- To calculate the real cost a borrower is paying on its loan, the nominal rate of interest is adjusted with the effect of inflation and thus the interest rate we get is known as the real interest rate.
- The real interest is always lower than the nominal interest rate if the inflation is taking place—the difference is the inflation premium.
- Rising inflation premium shows depleting profits of the lending institutions.
- At times, to neutralize the effects of inflation premium, the lender takes the recourse to increase the nominal rate of interest.
- In recent times, it was done by the Indian banks in July 2003 to ward off their depleting profits when inflation had crossed the 7 per cent level—the level of inflation was threatening to deplete even the capital base of the banks. Since then the RBI has been following a tighter credit policy as inflation was going beyond the upper limit of its healthy range (i.e., 4–5 per cent in the Indian case).
- So if there is a high rate of inflation , it will lead to erosion of capital of the financial institutions .
- The money invested in Fixed Deposits will also loose its real value if the inflation is higher than the the interest rate given on investment .
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