Final answer:
The annual increase in the dollar value of a financial asset is the (option a) nominal interest rate, but when considering inflation, the real interest rate is used to indicate actual gain in buying power.
Step-by-step explanation:
The annual increase in the dollar value of a financial asset is referred to as the nominal interest rate. However, this rate does not account for inflation.
When adjusting the nominal interest rate for inflation, we get what's called the real interest rate. This rate shows the actual increase in buying power.
When taxes come into play, things can get more complicated. For instance, U.S. income tax is charged on the nominal interest without considering inflation.
Consequently, if an individual invests $10,000 at a 5% nominal interest rate, they will be taxed on the $500 gain regardless of the inflation rate.
If the inflation rate is 0%, the real interest rate is the same as the nominal rate (5% in this case), which equates to a real gain.
However, if inflation is at 5%, the real interest rate becomes 0%, meaning there is no real gain, but the individual still owes tax on the $500 nominal gain.
Should inflation rise to 10%, the scenario worsens as the real interest rate turns negative (-5%), suggesting a loss in buying power, yet the tax liability on the nominal gain persists.