Question

Tom is considering an investment with an expected rate of return of 12%. If the inflation rate is 3%, what is the real rate of return?

Answer 1

To calculate the real rate of return, we can use the Fisher equation, which is given by:

\[
1 + r = \frac{1 + i}{1 + \pi}
\]

where:
- \( r \) is the real rate of return,
- \( i \) is the nominal rate of return (expected rate of return), and
- \( \pi \) is the inflation rate.

In this case:
- \( i = 0.12 \) (12%)
- \( \pi = 0.03 \) (3%)

Plugging in the values:

\[
1 + r = \frac{1 + 0.12}{1 + 0.03} = \frac{1.12}{1.03}
\]

Calculating the right side:

\[
1 + r = \frac{1.12}{1.03} \approx 1.0864
\]

Now, to find \( r \):

\[
r \approx 1.0864 - 1 = 0.0864
\]

Converting this back to a percentage:

\[
r \approx 0.0864 \times 100 \approx 8.64\%
\]

Therefore, the real rate of return is approximately **8.64%**.