Final answer:
The correct method to deduct inflation and find the real return is direct subtraction of inflation, using the percentage-change formula, not merely subtracting index numbers.
Step-by-step explanation:
When attempting to find the "real" return by deducting inflation, the correct method is A. Direct subtraction of inflation. However, it's important to understand that the simple subtraction of index numbers to find the inflation rate can be misleading. Instead, the precise calculation involves using the percentage-change formula. For instance, if a price index moves from 107 to 110, the inflation rate is calculated as 100 x (110 - 107) / 107 = 100 x 0.028 = 2.8%. This is more accurate than simply subtracting the index numbers, which might incorrectly suggest an inflation rate of 3%.
The percentage change formula maintains the ratio of index numbers proportionate to the total dollar cost of purchasing a basket of goods and provides a precise inflation rate. This method is especially important for accuracy when the base index number is not close to 100, as precision to tenths of a percent becomes critical.
For example, if the nominal return on an investment is 6% and the inflation rate is 2%, the real return would be 6% / 2% = 3%. This means that after adjusting for inflation, the investment has a real return of 3%.