The effect of inflation is to erode the purchasing power of money. A real rate of return is one that has been adjusted for inflation and measures the increase in purchasing power directly. Nominal returns are what are viewed in the market place and have not been adjusted for inflation.
Because purchasing power is lost over time, rational investors incorporate inflation into the return they require for foregoing consumption. This relationship is given by Fisher's theorem:
(1 + in) = (1+ ir) x (1 + ei) | (1) |
in = ir + ei + (ir x ei) | (2) |
in ≈ ir + ei | (3) |
where
in is the nominal interest rate,
ir is the real interest rate, and
ei is the expected rate of inflation over the long term.
The first two equations provide the mathematical relationship between nominal and real interest rates and inflation. Nominal interest rates are simply real interest rates 'grossed up' by an estimate of the anticipated rate of inflation.
For example, assume the 10-year nominal bond yield is 7.5% pa. The latest Treasury and Finance estimate for inflation over the longer term is 2.50% pa. The approximate 10-year real interest rate is therefore 7.50% - 2.5% = 5.00% pa. Using Fisher's equation, the exact real interest rate is [(1.07/1.025) - 1] which is 4.90% pa. The difference between the methods is 0.10% pa, not significant.
Project evaluation requires that a consistent approach be taken to the treatment of inflation. Real cash flows must be discounted at real discount rates and nominal cash flows at nominal discount rates.