Suppose that you lend me $100 for a year, and that I agree to pay you $110 at that time (principal plus interest). Over the intervening year, however, the average price of goods in the economy rises by 3 percent. The real rate of return that you will earn on your loan to me is therefore equal to

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The nominal rate of return on the loan is 10% ($110/$100 = 1.1 or 10%). However, due to inflation, the value of that $110 payment at the end of the year is worth only 97% of what it would have been worth at the beginning of the year ($110/1.03 = $106.80). Therefore, the real rate of return is only 6.8% ($6.80/$100 = 0.068 or 6.8%). To calculate the nominal rate minus the inflation rate, we get 10% minus 3% which equals 7%, or Choice B.

Suppose That You Lend Me $100 for a Year, and That