What is the effect of inflation on the return from a treasury bond?

The correct answer illustrates how inflation impacts the real rate of return from a treasury bond. When inflation rises, the purchasing power of the money earned from the bond decreases. Therefore, to understand the effect more clearly, we differentiate between nominal and real rates of return. The nominal rate refers to the stated interest rate without adjustment for inflation, while the real rate adjusts for the impact of inflation on purchasing power.

As inflation increases, the real rate of return is effectively reduced because the amount of money earned from the bond buys less in terms of goods and services. Thus, the real rate of return decreases by the amount of inflation. This demonstrates that while the nominal return remains constant, the true economic return investors receive is diminished, leading to a loss of purchasing power, which aligns with the correct answer.

Conversely, increasing inflation does not enhance the real rate of return or merely affect the nominal rate without impacting the real rate. Instead, it produces a scenario where the real rate is diminished by the rate of inflation. This reinforces the understanding that inflation is a critical factor influencing the actual economic benefit derived from bond investments.