Final answer:
If you buy a 30-year Treasury bond at a nominal interest rate of 4.5% and the inflation rate is 5%, the real interest rate would be negative 0.5%, meaning you would be losing purchasing power over time.
Step-by-step explanation:
If you had bought a 30–year Treasury bond at a nominal interest rate of 4.5% and inflation averages 5% over the next 30 years, then the real interest rate would be calculated as the nominal interest rate minus the inflation rate. In this scenario, the real interest rate would be:
Real interest rate = Nominal interest rate – Inflation rate
Real interest rate = 4.5% – 5%
Real interest rate = -0.5%
Therefore, the real interest rate would turn out to be negative 0.5%. This negative real interest rate indicates that the purchasing power of the interest payments is less than the original amount invested, due to the inflation rate being higher than the nominal interest rate.
The effect of inflation can erode the value of nominal returns over time, leading to a situation where the investor effectively loses money in terms of buying power, despite the nominal gains. The issue can be exacerbated by taxes, as they are levied on the nominal gains without considering inflation, resulting in a tax burden even when the real return is zero or negative.