5Interest rates are the return to be earned from holding an asset such as a government bond or a loan to private borrower.
When that return is expressed as the amount of currency received as a percentage of the principal it is referred to as the nominal rate of interest. So, for example, if A makes a one-year loan to B of £100 and receives £103 at the end of the year the nominal interest rate is 3%.
If during that year the price of a typical good has risen from £1 to £1.02, i.e. there is 2% inflation, that £103 will buy only approximately 101 goods. So A has sacrificed the ability to buy 100 units of goods at the beginning of the year in return for the ability to buy 101 goods at the end of it. A’s real return (i.e. the return measured in goods rather than currency) is only 1%. The real interest rate is (approximately) equal to the nominal interest rate minus the inflation rate.
Long-term interest rates are the interest rates on loans whose principal is not due to be repaid for a number of years. Short-term interest rates are the interest rates on loans whose principal is due to be repaid within months or even days.
Typically long-term and short-term nominal interest rates show similar behaviour over long periods of time but short-term interest rates tend to be more volatile. The behaviour of short and long-term interest rates on UK government bonds since the late 1970s illustrates these points: both interest rates have tended to fall, the long-term interest rate more steadily.