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Real versus Nominal Interest Rates

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40. The interest rate on conventional 10-year Treasury bonds is 7% per year and the interest rate on 10-year TIPS (Treasury inflation-protected securities) is 3.5% per year. You have $10,000 to invest in one of them.

a. If you expect the average inflation rate to be 4% per year, which bond offers the higher expected rate of return?

b. Which would you prefer to invest in?

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This posting answers the given problem regarding real vs. nominal interest rates.

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a. In real terms, the expected rate of return on the nominal bonds is

(7% - 4%)/1.04 = 2.885%, which is less than ...

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