Question

The true cost of borrowing and lending is best measured by

Answer 1

The true cost of borrowing and lending is best measured by the real interest rate. Real interest rate adjusts the nominal interest rate by inflation. (Real interest=Nominal interest-Inflation)

 Let us consider two instances:
 Instance 1 : Nominal interest rate is 5% and CPI inflation at 2.8%.
 Instance 2 : Nominal interest rate stays at 5% and CPI inflation at 3.5%.

During Instance 2, for an unassuming lender, though it looks like he is not impacted, inflation has taken away some of his purchase power while the interest he earns is the same. Likewise a low inflation rate will have a hidden impact for the borrower and beneficial for the lender.

 Instead, if we take real interest into account, first instance had a real interest rate of 2.2% and the second instance had a real interest rate of 1.5% which explicitly shows the impact of the higher inflation rate and thus reflects the true cost of borrowing/lending.