Canadian Securities Course (CSC) Level 1 Practice Exam

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How do inflation and interest rates impact the real rate of return?

If inflation rate is higher, real return is lower
If interest rates rise, real rate decreases
If inflation is lower, real return is higher
If interest rates decrease, real rate increases

The correct answer is: If inflation rate is higher, real return is lower

Inflation and interest rates both play significant roles in determining the real rate of return. When the inflation rate is higher, the purchasing power of the returns earned on an investment decreases. This is because the nominal return (the return before considering inflation) needs to be adjusted for the impact of inflation to determine the real rate of return. Therefore, when the inflation rate is high, the real rate of return tends to be lower as the purchasing power of the investment decreases. In the context of the other options: If interest rates rise, it typically leads to lower real rates of return because higher interest rates can erode the value of investments. If inflation is lower, the real return tends to be higher since the purchasing power of the returns is not being eroded as much. If interest rates decrease, the real rate of return usually increases as the returns from investments may hold more value in a lower interest rate environment.