The Real Rate of Return
The rate of return that a bond (or any investment) offers is made up of two components:
- The real rate of return
- The inflation rate
Because inflation reduces the value of a dollar, the return that is received, called the nominal rate, must be reduced by the inflation rate to arrive at the real rate of return.
Nominal Rate = Real Rate + Inflation Rate
Did You Know?
The real rate of return is determined by the level of funds supplied by investors and the demand for loans by businesses. The supply of funds tends to rise when real rates are high because investors are more likely to earn higher returns on the funds they lend. On the other hand, the demand for loans tends to rise when real rates are low because businesses that borrow to invest in their companies are more likely to earn returns that are higher than the costs of borrowing.
The nominal rate for loans is made up of the real rate, as established by supply and demand, plus the expected inflation rate, as shown in Figure 7.7.
Here is the key formula for calculating the nominal rate of return:
$$
(\text{Nominal Rate} = \text{Real Rate} + \text{Inflation Rate})
$$
Factors Affecting Real Rate Forecasts
Two major factors affect forecasts for the real rate:
-
The Business Cycle
- The real interest rate rises and falls throughout the business cycle.
- During a recession, the real rate falls along with the demand for funds.
- When rates fall sufficiently, the demand starts to rise again.
- As the economy expands, demand for funds continues to grow, and the real rate rises in tandem.
-
Unexpected Changes in the Inflation Rate
- Investors demand an interest rate that includes their expectations for inflation, ensuring a satisfactory real rate.
- If the inflation rate is higher than expected, the investor’s real rate of return will be lower than expected.
Example Calculation
If the real rate of return on a bond is 3%, and the expected inflation rate is 2%, the nominal rate is calculated as follows:
$$
(3\% + 2\% = 5\%)
$$
The nominal rate of return would, therefore, be 5%.
Frequently Asked Questions (FAQ)
What is the nominal rate of return?
The nominal rate of return is the rate of return on an investment before adjusting for inflation.
How does inflation impact the real rate of return?
Inflation erodes the purchasing power of money; hence, the return received on an investment must be adjusted for inflation to determine the real rate of return.
Can the real rate of return be negative?
Yes, the real rate of return can be negative if the inflation rate exceeds the nominal rate of return.
Glossary and Definitions
- Real Rate of Return: The rate of return on an investment after adjusting for inflation.
- Nominal Rate: The rate of return on an investment without adjusting for inflation.
- Inflation Rate: The percentage rate at which the general level of prices for goods and services rises, diminishing the purchasing power of money.
Key Takeaways
- The real rate of return is crucial for understanding the actual profitability of an investment.
- Nominal rates need to be adjusted for inflation to assess true returns.
- The business cycle and unexpected changes in inflation significantly influence the real rate of return.
Charts and Diagrams
pie
title Composition of Nominal Rate
"Real Rate": 40
"Inflation Rate": 60
📚✨ Quiz Time! ✨📚
## What are the two components that make up the rate of return on an investment?
- [ ] Nominal rate and interest rate
- [ ] Inflation rate and discount rate
- [x] Real rate of return and inflation rate
- [ ] Real rate of return and risk premium
> **Explanation:** The rate of return is composed of the real rate of return and the inflation rate. These two factors combined give the nominal rate of an investment.
## How does inflation affect the nominal rate of return?
- [ ] It increases the nominal rate
- [x] It reduces the value of the nominal rate in real terms
- [ ] It has no effect on the nominal rate
- [ ] It changes the nominal rate unpredictably
> **Explanation:** Inflation reduces the value of a dollar over time, so the nominal rate needs to be adjusted for inflation to find the real rate of return.
## What tends to happen to the supply of funds when real rates are high?
- [ ] The supply of funds decreases
- [x] The supply of funds increases
- [ ] The supply of funds remains constant
- [ ] The supply of funds becomes erratic
> **Explanation:** When real rates are high, investors are motivated to supply more funds because they can earn higher returns.
## How does a low real rate affect the demand for loans?
- [ ] Demand for loans decreases
- [x] Demand for loans increases
- [ ] Demand for loans remains unchanged
- [ ] Demand for loans fluctuates wildly
> **Explanation:** Low real rates encourage businesses to borrow since the cost of borrowing is low relative to potential returns on investments.
## What forms the nominal rate for loans?
- [ ] Real rate + Interest rate
- [ ] Real rate + Risk premium
- [x] Real rate + Inflation rate
- [ ] Real rate + Economic growth rate
> **Explanation:** The nominal rate is the sum of the real rate and the expected inflation rate.
## How does the real interest rate typically change during a recession?
- [x] It falls
- [ ] It rises
- [ ] It remains constant
- [ ] It becomes unpredictable
> **Explanation:** During a recession, demand for funds decreases and thus the real interest rate typically falls.
## What occurs when the inflation rate is higher than expected?
- [ ] The real rate of return increases
- [x] The real rate of return decreases
- [ ] The real rate of return remains unaffected
- [ ] The real rate of return becomes negative
> **Explanation:** If inflation is higher than expected, it reduces the purchasing power and overall real rate of return for an investor.
## What is the behavior of demand for funds as the economy expands?
- [ ] It decreases
- [x] It increases
- [ ] It becomes unstable
- [ ] It remains unchanged
> **Explanation:** As the economy grows, businesses seek more funds for expansion, leading to a higher demand for funds.
## Why do investors demand an interest rate that includes expected inflation?
- [ ] To ensure maximum borrowing
- [ ] To lower the nominal rate
- [ ] To minimize risk
- [x] To ensure a satisfactory real rate of return
> **Explanation:** Investors incorporate expected inflation into the interest rate to maintain their purchasing power and achieve a satisfactory real rate of return.
## Which of the following best describes the 'nominal rate'?
- [x] The sum of the real rate and the inflation rate
- [ ] The rate maintained after inflation adjustments
- [ ] The rate before considering any inflation impact
- [ ] The rate determined by market speculation
> **Explanation:** The nominal rate is the sum of the real rate and the inflation rate.