(This post is a part of the series on Basics of Finance and Investing.)

You have bought a 1-year CD for $10,000 at 5% interest rate. After one year you collect $10,500 - a gain of $500. What is your real gain? This depends on what $10,000 can buy one year later, compared to what it does now.

Inflation, the rate at which the prices of goods and services grow with time, will reduce the purchasing power of your original $10,000 investment after one year. Changes in the consumer price index, or CPI (computed as the average price of consumer items purchased by a typical urban family of four), is the standard measure of inflation .

At the current annual inflation rate of 2.5%, you will pay $10,250 after a year to maintain the purchasing power of $10,000 today. So, in effect, what you really gain is $250 (=$10,500-$10,250). In other words, your real interest rate, which defines the growth of your purchasing power, is 5 - 2.5 = 2.5%. The original 5% is the nominal interest rate, which determines the growth of your asset.

Suppose the real and nominal interest rates are r and R, and i is the inflation rate. If the invested amount is a, then the nominal increase after one year should equal the real increase multiplied by inflation. That is, a(1 + R) = a(1 + r)(1 + i), which gives r = (R - i)/(1 + i). When i is much smaller than 1 (like in our example, where 0.025 << 1), we have the approximate relationship

r = R - i.

This is a formal way to present our example. So, higher the inflation, less is the real gain from a fixed-income type investment. Interest rates offered by both the money market and bond market securities are only nominal rate, which you should keep in mind while estimating your asset growth.

Go on to what determines the real interest rate.

See related posts:

1. What determines the "real" interest rate?
2. Basics of Finance and Investing
3. Why should we invest?
4. Inflation and retirement