Real Growth and Expected Inflation Formula

B

By definition: Nominal risk-free rate = (1 + Real Growth) (1 + Expected Inflation) - 1.

The correct answer to the question is B. Nominal risk-free rate.

The formula given in the question is:

________ = (1 + Real Growth) (1 + Expected Inflation) - 1.

To understand this formula, let's break it down into its components:

1. Real Growth: Real growth refers to the growth rate of the economy or an investment adjusted for inflation. It represents the increase in the purchasing power of goods and services. Real growth is usually expressed as a percentage.

2. Expected Inflation: Expected inflation refers to the anticipated increase in the general price level of goods and services over a specific period. It is also expressed as a percentage.

Now, let's analyze the formula step by step:

(1 + Real Growth): This term represents the growth in the economy or an investment, adjusted for inflation. Adding 1 to the real growth rate accounts for the fact that the economy or investment is growing.

(1 + Expected Inflation): This term accounts for the expected increase in prices due to inflation. Adding 1 to the expected inflation rate represents the adjustment for future price levels.

(1 + Real Growth) (1 + Expected Inflation): Multiplying these two terms together incorporates both the real growth and the expected inflation.

(1 + Real Growth) (1 + Expected Inflation) - 1: Subtracting 1 from the result adjusts for the fact that we are interested in the rate of return or discount rate, not the growth rate itself. The subtraction of 1 ensures that the result is expressed as a decimal rather than a percentage.

Based on this analysis, the correct answer is B. Nominal risk-free rate. The formula represents the calculation of the nominal risk-free rate, which is the rate of return required on an investment that carries no risk and is not subject to inflation. It incorporates both the expected inflation and the real growth rate to arrive at the nominal risk-free rate.