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Real and nominal return

The real interest rate reflects the additional purchasing power gained and is based on the nominal interest rate and the rate of inflation. Learn how to find the real interest rate in this video. Created by Sal Khan.

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  • male robot donald style avatar for user Pedro Miguel Fernandes da Silva
    I think we can talk about real interest rate (discounting inflation) and nominal interest rate. With that assumption, i thought that the real interest rate were simply calculated by substrating the inflation value to the nominal interest rate.

    How come that with the example given in the video the result is 7,8% and not 8% (real interest rate = nominal interest rate - inflation rate => 8 = 10 - 2)?
    (42 votes)
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    • mr pants teal style avatar for user Wrath Of Academy
      Great question - I thought Sal might do simple rate subtraction. However, this division method he uses is more realistic. Consider a really extreme example where your investment rate is 200% (so you triple your money after a year) and inflation is 100% (so you'd need to double your money after a year just to stay even). So now you have $100 - in a year you get $300. Inflation means you need $200 in a year just to stay even. So the division method is (300-200)/200 or 50%. That should make sense because $300 is really 50% better than $200 - that's how far you run in front of inflation in a year. The subtraction method would be 200% - 100% = 100%, and that's clearly not right - you didn't out-pace inflation by 100%. (To beat inflation by 100%, you would need $400 in a year - double the inflation-adjusted value of $200.)
      (58 votes)
  • blobby green style avatar for user huda
    what is the meaning of diversification?
    (17 votes)
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  • blobby green style avatar for user santhosh
    Why does govt changes interest rates when inflation changes?
    (0 votes)
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    • purple pi purple style avatar for user Peter
      when a central bank changes the interest rates, and the retail banks follow, it affects the amount of spare money in people's pockets.
      A clear example is a mortgage.
      When the central bank increases rates, athe the reatil banks follow suit, my mortgage payments go up (I have a flexible rate mortgage). Mortgage rates go uop for folks wanting to remortgage.
      Because I have less money left at the end of the month, my consumption of other goods and services drops.
      Because the consumption of good and services drops, a downwards pressure is exerted on prices, which causes inflation to drop (or be less high than otherwise).

      The opposite is also true.
      When central bank rates drop, folks can get cheap credit, and are likely to increase their consumption of goods and services, which in turn means that an upwards pressure is exerted on prices, causing them to rise (and thus price inflation), or to fall more slowly than otherwise (heading off a recession/deflation, like has happened in many countries post 2007/8, and even longer in Japan).
      (4 votes)
  • marcimus pink style avatar for user Agnieszka
    Wouldn't it be more practical to measure the output of an economy in goods produced/sold and not in money value?
    (1 vote)
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  • blobby green style avatar for user Tado Lehnsherr
    what is nominal money and real money? Can you give some examples of real money?
    (2 votes)
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  • male robot hal style avatar for user HarkeeratS
    How did he get 102 from 2% .
    (1 vote)
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  • blobby green style avatar for user Pranav Rajkumar
    This was very helpful. However, I have a small doubt. This was for a cashflow of 1 year. Say we have a $100 investment which we held for 5 years. It's given us a CAGR of 10%. Say the average inflation rate during those 5 years is 5%. How would I calculate my real rate of return then ?
    (1 vote)
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  • mr pants purple style avatar for user Shilpa Prasad
    lnflation measures change in
    (A) Absolute prices
    (B) Relative prices
    (C) Both absolute and relative prices
    (D) All of the above
    (0 votes)
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  • leafers seedling style avatar for user liularkin
    so the nominal return equals return money / previous year and real return equals to return money / today. is it right?
    (0 votes)
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  • aqualine ultimate style avatar for user stbiyela04
    Why would he say 8/102=7.8%
    (0 votes)
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Video transcript

Let's say last year I put $100 into some type savings account in a bank. So this is a year ago. And that now today, exactly one year later, that $100 has grown to $110. So this is now. So if you look at things just in the absolute dollar terms, things have grown by $10. So I made $10 off of an original $100 investment. So I got a 10% return. But what I want to think about is does this really capture how much more I can buy with this $110 than I could buy with that $100 before. Can I really by 10% more goods and services today than I could a year ago? And to think about that, let's think about a hypothetical inflation rate from last year to this year. So let's say that the inflation ended up being 2% between a year ago and today. If that's the case, what is $100 a year ago in today's money? Well, if inflation was 2%, then $100 a year ago would buy you the same stuff that $102 would buy you today. So it would be $102. So what is the dollar return in today's money, the current purchasing power? Well, we're getting $110. And we invested in today's money $102. If we look at it from today's terms, we invested something that gives us the same purchasing power as $102 today. And now it's giving us a purchasing power of $110. So we've gotten $8 more of purchasing power in today's money. So what is the actual real return? And we can do it in today's money. And you could do it either way. You could discount the 110 back to a year ago money and figure out the real return there, and figure out the product actual dollar return, and do the calculation. Or you can do it in today's money. And maybe I'll do it the previous way in the next video. But the real return is we made $8 over the course of the year in today's money. And what we originally invested in today's money was $102. And so we get our calculator out. 8 divided by 102 is 7.8%. So this is equal to 7.8%. So even though the nominal return, if we just look at what we got in exchange for what we invested, even though the nominal return was 10%, because there was 2% inflation our actual purchasing power only increased by 7.8%.