Calculating the Real Rate of Return (Finance)

Suppose we can invest our money at 10% into an account for 1 year, but we expect the rate of inflation to be 5%. At the end of the year, we will have $110 saved, but $100 worth of goods before now costs $105 a year later. Therefore, by investing and deferring our purchasing decisions, we really only have $5 extra, not $10.

• In one year, what is the actual purchasing power or real rate of return for this investment considering inflation?

Real rate of return is the growth in purchasing power available after considering the effects of inflation. By calculating the real rate of interest (i_real), we get the actual purchasing power which adjusts for inflation. The real rate of interest is not intended to be used as a nominal rate for calculating the future value of current savings.

Real rate of interest i_real=(i−r)/(1+r)

Where:
• i is the nominal interest rate and
• r is the inflation rate

Q. Marc invests at 5.39% annual interest; however, Marc expects inflation to be 3.1%. What is his real rate of return?