Question

Assume you can earn 1% per year by investing in CDs at your local bank but expected inflation will be 2.2% per year. How should one interpret this in practical terms?

Answer 1

Real rate of return earned = ((1 + nominal return) / (1 + inflation rate)) - 1

Real rate of return earned = ((1 + 1%) / (1 + 2.2%)) - 1

Real rate of return earned = -1.17%

In practical terms, this means that the real rate of return earned on the CDs is negative. This means that the real value of your investment is decreasing, since inflation is higher than the return earned. You should seek out other investments which have a higher nominal return, so that the real rate of return earned is positive.