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## Finance and capital markets

### Course: Finance and capital markets>Unit 3

Lesson 3: Real and nominal return

# Real and nominal return

AP.MACRO:
MEA‑3 (EU)
,
MEA‑3.B (LO)
,
MEA‑3.B.1 (EK)
,
MEA‑3.B.2 (EK)
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.

## Want to join the conversation?

• 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)?
• 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.)
• what is the meaning of diversification?
• diversification = spreading out the risk, think of the phrase never put all your eggs in one basket (If the basket is dropped, all is lost.) diversification is putting your eggs in a bunch of different baskets
• Why does govt changes interest rates when inflation changes?
• 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).
• Wouldn't it be more practical to measure the output of an economy in goods produced/sold and not in money value?
(1 vote)
• And that also doesn't take into account non-good services, and considering a significant portion of most economies is the service sector, that's not the most practical option.
• what is nominal money and real money? Can you give some examples of real money?
• Nominal money is the actual amount of money you have at a given moment without taking into account inflation. People use Real Money to take into account the change in price level.
• How did he get 102 from 2% .
(1 vote)
• \$100 times 2% is \$2. That added to the original \$100 is \$102.
• 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)
• go back to Sal's videos on infaltion.
Remember when he uses (1+r)^n.
(1 vote)
• lnflation measures change in
(A) Absolute prices
(B) Relative prices
(C) Both absolute and relative prices
(D) All of the above
• A - absolute prices. Inflation is basically looking at "how much does this cost now?" and "how much did this cost back in X year?" and doing the math to see the variance.