Question

What’s the point of this formula? And why do investors want to be compensated for inflation? & how does that erode our purchasing power ?

This is known as te "Fsher Efect" ordrs aur Pthasing powc Evamec If the nomno Inc ro is i. Ineuun is oomed i. hui Inriohon is 51. So I pamda nal rtun on 012

Answer 1

Answer

• Yes, the formula indeed includes a premium that would compensate the investor for inflation.
• We know that the value of money decreases over time as a result of inflation.
  For example, we use to get a whole lot amount of gas in $2 in the past.
  Now, so many years later, how much gas can we get in $2? Certainly not as much as we used to get.
  This is because, the gas priced have increased, OR we can say that value of money ($) has decreased OR that our purchasing power has decreased.
• Same concepts applies here.
• Fisher Effect states that REAL INTEREST rate = Nominal Interest rate – Inflation rate.
• This means that the interest rate that the investor is getting (nominal rate) is not the actual rate he’s earning. That’s because of the inflation.
  Lets have an example.
  Mr A Invested in current year $ 10000 for 10% nominal interest in a bank for 1 year.
  In current year suppose there is a commodity worth $ 5000.
  Now in current year, Mr A can get 2 units of such commodity [$10000 / $5000]
  Say that inflation rate is 5%.
  
  After 1 year, Mr A’s investment would be $ 11,000 [$ 10000 + $1000 interest]
  The same commodity would cost now $ 5,250 [$5000 + $250 inflation]
  Now how many units would Mr A can get. Answer = $11000 / $5250 = 2.1 units.
  
  As the formula states, Real Interest rate = Nominal interest rate – Inflation rate.
  hence, real interest rate = 10% - 5% = 5%

Now, lets verify that formula:
Real Interest = (Additional no. of units that can be purchased/Original units that can be purchased) x 100
= (2.1 units – 2 units) / 2 units
= (0.10 units/2 units) x 100
= 5%