Question

Why does inflation reduce the rate of return on an investment?

Answer 1

Inflation reduces the real rate of return on an investment.

This is because inflation reduces the purchasing power of money. Inflation increases the general price level in the economy, and thus an equal amount of money is worth less in the future than today because it can purchase less.

If an investment returns 10% nominally, but inflation is 5%, then the real rate of return earned is less than 10% because the money earned on the investment is worth less in the future (after the investment returns are actually received).

As a result, the real rate of return is lower than the nominal rate of return. The real rate is the nominal rate after adjusting for inflation.