Question

An investment offers a total return of 11 percent over the coming year. Alex Hamilton thinks the total real return on this investment will be only 7.9 percent. What does Alex believe the inflation rate will be over the next year

Answer 1

Answer:

2.87%.

Explanation:

The total return, also refer to as Nominal return or Money return, is based on the nominal interest rate. For example, let's say that you deposited $100 into a bank account and the bank offers you an annual return of 11%. This 11% is the stated interest rate, it is known as nominal interest rate, and it is rate before taking into account the effect of inflation. When we deduct the effect of inflation from nominal rate, it gives us the real rate. Real rate reflects the Purchasing Power. The Fisher equation will be used to determine the expected inflation rate. The Fisher equation is as follows:

                                            (1 + i ) = (1 + r) * (1 + h)

where

i = Nominal (Money) rate

r = Real rate

h = Inflation rate

Simply adjust the equation to calculate the inflation rate;

⇒ h = [(1 + i) / (1 + r)] - 1

OR h = [(1 + .11) / (1 + .079)] - 1 = 2.87%.