The relationship between nominal returns, real returns, and inflation is referred to as the “inflation-adjusted return.” Over the past few years, inflation has become a major issue that economists and investors have been paying attention to. So much so that we have seen the Federal Reserve put in place a mandate to control inflation.
The inflation-adjusted return is the “real” return that we calculate based on our price index. The nominal return is the return that we obtain through the calculation of a price index. The inflation-adjusted return is the inflation-adjusted return that we get by the simple addition of nominal returns. When inflation and nominal returns are equal, then the nominal return should be equal to the inflation-adjusted return.
We can all agree that inflation is a big deal because it affects money supply, economic growth, and how we spend money. A great deal of research has gone into determining what inflation is, what it correlates to, and what it does to the economy. Most of the research is based on academic studies.
The relationship between inflation and nominal returns has been a long-running debate. In some cases, it goes back further in time. For example, the relationship between real-time inflation and real-time real returns. Before the advent of the gold standard, the relationship between inflation and nominal returns was very much based on the relationship between nominal returns and nominal returns. So, in this sense, real-time inflation can be considered as the inflation-adjusted return.
For example, back in the 1930s, the inflation rate was much lower than today. So, the rate of real returns would be much higher than today. However, inflation-adjusted returns would be much lower than today. That is to say, a lower real-time inflation rate means a higher real-time nominal return.
So, nominal returns is the inflation rate adjusted for real returns. The real-time inflation rate is the inflation rate adjusted for real returns and the nominal return is the inflation rate adjusted for real returns. So, you could put a value on Real-time Inflation as the Real-time Inflation adjusted for Real-time Inflation. This is called nominal inflation.
Nominal returns are what you normally pay for in your bank and that you receive in return. When the inflation rate is high nominal returns should be higher and vice versa.
Nominal returns are called nominal returns because you are being paid a fixed amount of money and that amount is what you should be paid all the time in the future, nominal returns are basically what you should be paid all the time in the future. When inflation is high, nominal returns should be higher. When inflation is low nominal returns should be lower. Real-time Inflation adjusts the nominal rate for real returns and nominal returns adjust the real-time inflation rate.
Real returns are always at a constant rate because they are computed based on the money supply at a certain point in time. On the other hand, nominal returns are usually more volatile because they are computed for the money supply at a certain point in the future. On the other hand, nominal returns can go up or down, real returns can go up or down, but nominal returns can never go down.
Nominal returns are the “present value” of future cash flows. The nominal return is the number of dollars you expect to earn on your investment over time. If you expect to earn $10 in interest and $1 in a year, then the nominal return is 9,000. You might also say that $1.00 in a year is 10,000. The real return is the number of dollars you earn in future cash flows divided by the number of dollars you invested.