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Studying for a test? Prepare with these 5 lessons on Inflation - measuring the cost of living.

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# Real and nominal return

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%.