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Lesson 19: Nominal Versus Real Returns Adjusting for Inflation

Module 1: Macro Fundamental Analysis

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Video Transcript

in this lesson we’re going to look at nominal versus real returns now we touched on these terms earlier on in the course and we’re going to look at exactly what this means and how you can calculate this right in this tab here so we discussed before nominal is simply not adjusted for inflation and real is simply adjusted for inflation so nominal returns returns are not adjusted for inflation real returns returns adjusted for inflation nominal interest rates interest rates not adjusted for inflation real interest rates interest rates adjusted for inflation so on the left hand side here you can see once again we have price level and price level is again just simply a basket of goods and services within this economy and it’s the average price of all of those goods and services so some transportation costs some beer some housing fuel and all kinds of goods and services thrown into a basket and averaged out so we can see and if we work in dollars once again that in january 2019 the average level of goods and services within the economy is one dollar and this increases on a year-over-year basis to 1.02 so in 2019 the average price of the basket of goods and services within the economy is one dollar and that same exact basket of goods and services in the same economy is worth 1.02 on average in the year 2020. so what this means is that we have an inflation rate of two percent because if we click on this you can see this is just simply a percentage increase between b8 and b4 so the percentage increase from 100 to 102 which is two percent so working out the inflation rate is the first thing we need in order to determine nominal versus real returns the second thing here is the investment so what we’re looking at here in terms of dollars is an investment which was made in january 2019 and it was a hundred dollar investment that could be to purchase an asset let’s say within the economy and a year later in 2020 so january 2020 that same investment is now worth 120 so you spent 100 in january 2019 to purchase an asset that asset a year later is worth or valued at 120 so after we’ve established the inflation rate so the change percentage change in the average level of goods and services within the economy from year to year the second thing we need to do in this area is to take our initial investment which is a hundred dollars and adjust it for inflation so this is simply a hundred dollars adjusted for the two percent inflation rate and by doing this what we’re doing is all we’re simply doing is we are finding out the value of last year’s 100 in today’s money so that’s 100 last year adjusted for inflation is 102 this year so now we have our rate of inflation worked out and we have our initial investment adjusted for inflation we can see that our nominal return on our investment from 2019 is 20 we invested 100 and it’s worth 120 dollars so this is simply b9 minus b5 leaves us with 20 as a nominal dollar return on investment if we change that into a percentage so simply looking at the percentage increase from investment in january 2019 to january 2020 value we can see this is a 20 percent increase so 100 to 120 20 nominal return on investment is 20 of our original investment so our nominal return on investment in terms of dollars is 20 and our nominal return on investment in terms of percentages is 20 now if we adjust that for inflation and we look at our real return on investment all we do here is we take b9 so our investment value in january 2020 and we minus from that our inflation adjusted initial investment of 102 and that leaves us with 18 so you can see when we adjust for inflation here our real return on investment adjusted for inflation is actually 18 because two of those dollars are simply inflation our real return on investment as a percentage you may think on the surface it would be 18 but it’s actually 17.65 why because if we look at this what we’re taking is the 18 dollars which is our real return on investment and we’re just simply dividing it by the inflation adjusted initial investment to find out what the difference is between the 100 in today’s money and the hundred and twenty dollars in today’s money and so it’s not 18 over 100 it’s 18 over 102 and that gives us a real return on investment of 17.65 so our perceived change in purchasing power our nominal return on investment is 20 but when we adjust that for inflation our real change in purchasing power is actually 17.65 because the rest of that gain is actually accounted for by inflation