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## Finance and capital markets

### Unit 3: Lesson 3

Real and nominal return

# Relation between nominal and real returns and inflation

Relation between nominal and real returns and inflation. Created by Sal Khan.

## Want to join the conversation?

• At the end of the video, Sal says that (1+N)=(1+R)(1+I) makes a ton of sense.
Why is that, from a basic theoretical standpoint? • at - where did the first 1+I (the denominator) goes? He cancels the numerator, but where does the denominator go? • • An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. in other words: The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.
• I still dont get why Sal is simplifying at the end in green color? any simple explanation? thank you! • How did he get rid of P? Theres only one P for each? At • • I can see how "( ( 1 + N ) - ( 1 + I ) ) / ( 1 + I ) = Real Rate" is a useful formula given that the principal (P), the nominal rate (N), and the inflation rate (I) are pre-determined and a financial advisor or economist would be tasked to find the real rate of return for a client or an employer, etc.

How is the end game of this video, resulting in "( 1 + N ) = ( 1 + R ) ( 1 + I )", an applicable equation in a real life scenario? For example would it be useful for the same financial advisor or economist to cross-check or provide proof of their work? Just curious, thanks! • throughout the video, Sal says "compounded by nominal/real interest rate". what does that mean?
(1 vote) • compound is a tricky word that has a nuanced meaning. The most useful definition here would be something along the lines of "to make bigger or greater by counting all the parts of the whole"
So you are taking the the original amount and ending up with a new amount (the new "whole") that counted the original amount and the effect of the interest rate (the "parts" of the "whole").
Therefore you a compounding the original to arrive at the new.

If that still is not clear, here is a physical analogy: A compound bow is a bow that uses a pulley system to compound the amount effort spent drawing the bowstring.
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