If Kate achieved an investment return of 5% per annum and inflation over the same year was 2%, what real rate of return did she achieve?

• A. 3%
• B. 2%
• C. 7%
• D. 5%

Answer: (A)

Real rate of return measures how much your purchasing power grows after inflation. If Kate earns 5% and inflation is 2%, her money’s buying power increases by about 3%. Using the precise formula (1 + 0.05) / (1 + 0.02) − 1 gives 1.05/1.02 − 1 ≈ 0.0294, i.e., about 2.94%, which rounds to 3%. So the real rate of return is roughly 3%. The other options don’t fit because they either understate or overstate the effect of inflation on the nominal gain.