Final answer:
The real rate of return is the nominal rate of return minus the inflation rate. Taxation can complicate this by taxing nominal gains without accounting for inflation, which may lead to a zero or negative real interest rate but still result in a tax liability.
Step-by-step explanation:
The real rate of return is calculated by subtracting the rate of inflation from the nominal rate of return. So, if we consider an example where the nominal interest rate is 7% and the rate of inflation is 3%, the real rate of return would be 4%. In contrast, if there is deflation of 2%, the real interest rate would increase to 9%. This increase can lead to detrimental effects on borrowers and the overall economy, potentially resulting in a larger number of loan defaults and a possible recession due to a decrease in aggregate demand.
Tax implications can further complicate the situation. In the U.S., income tax is levied on the nominal gains without adjusting for inflation. This means that in scenarios where the inflation is equal to or higher than the nominal interest rate, individuals can have a zero or negative real interest rate but still owe taxes on the nominal gains.