If the rate of inflation is 5%, what nominal interest rate is necessary for you to earn a 3% real interest rate on your investment?
8%, if you ignore taxes.
Tax rates on interest income depend upon income level, whether you are in the AMT category, and the type of fixed-income investment. Municipal bonds and money market funds that hold them are tax free in the USA.
To calculate the nominal interest rate required to earn a specific real interest rate, we need to account for the inflation rate. Here's how to determine the nominal interest rate:
Step 1: Start with the real interest rate. In this case, the real interest rate is 3%.
Step 2: Add the inflation rate to the real interest rate. In this case, the inflation rate is 5%, so add 5% to 3%, which equals 8%.
Step 3: The result obtained in step 2 is the nominal interest rate needed to earn a 3% real interest rate. Thus, you would need an 8% nominal interest rate on your investment to achieve a 3% real interest rate after accounting for 5% inflation.