---
title: "Short note: market vs inflation-free interest rate"
subject: "Engineering Economics"
chapter: 8
key: "semester_6/engineering_economics:short-note-market-vs-inflation-free"
source: https://www.bctengineer.com/q/semester_6/engineering_economics/short-note-market-vs-inflation-free
site: BCT Engineering
---

# Short note: market vs inflation-free interest rate

Engineering Economics · Chapter 8: Inflation and Its Impact on Project Cashflows

- Asked in: 2069 Poush
- Video: [✅2080 to 2069 | Inflation full chapter| 5+ question solved| engineering economics](https://www.youtube.com/watch?v=564K0T_Ws-k) — Revise with Roshan 
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_6/engineering_economics/short-note-market-vs-inflation-free
- Whole chapter: https://www.bctengineer.com/md/semester_6/engineering_economics/chapter-8

## Question

Write a short note on market interest rate and inflation free interest rate.

## Short answer

Market interest rate (i) is the quoted rate that includes inflation compensation, used for actual-dollar cash flows. Inflation-free rate (i') is the real rate reflecting true purchasing power growth, used for constant-dollar cash flows. They relate as i = i' + f + i'f; for i=13% and f=5%, i' = 7.62%.

## Answer

#### Market interest rate (i)
The market (combined or nominal) interest rate is the rate actually quoted and earned or paid in the market, such as the bank loan rate or MARR. It contains compensation for inflation as well as the real return on capital, so it is used for **actual-dollar** cash flows.

#### Inflation-free interest rate (i')
The inflation-free (real) interest rate is the rate that would apply if there were no inflation, i.e. the true growth in purchasing power. It is used for **constant-dollar** cash flows.

#### Relationship
With general inflation rate f:
```text
i = i' + f + i'f           (market rate)
i' = (i − f) / (1 + f)     (inflation-free rate)
```
Example: market rate 13%, inflation 5% → i' = (0.13 − 0.05)/1.05 = 7.62%. Conversely, if i' = 6% and f = 5%, then i = 0.06 + 0.05 + 0.003 = 11.3%.

#### Use
| Cash flows in | Discount at |
|---|---|
| Actual (current) dollars | market rate i |
| Constant (real) dollars | inflation-free rate i' |

Both approaches give the same present worth if applied consistently. Mixing them (for example discounting constant-dollar cash flows at the market rate) is a common error that understates the value of a project.

## Check yourself

The answer's key points as multiple-choice questions, with the correct option and why.

1. Which cash flows are discounted at the market interest rate?
   A. Constant-dollar cash flows
   B. Actual-dollar cash flows
   C. Only salvage values
   D. Only tax payments
   Answer: B. The market rate includes inflation compensation, so it matches actual dollars; the inflation-free rate matches constant dollars. (Key point: Market rate)

2. If market rate is 13% and inflation 5%, what is the inflation-free rate?
   A. 8%
   B. 7.62%
   C. 18.65%
   D. 6.5%
   Answer: B. i' = (0.13 - 0.05)/1.05 = 7.62%. (Key point: Conversion)

3. What happens if constant-dollar flows are discounted at the market rate?
   A. The result is exactly correct
   B. The project value is overstated
   C. The project value is understated
   D. Only the IRR is affected
   Answer: C. Mixing the two approaches discounts too heavily, understating the value of the project. (Key point: Common error)

## Related in Engineering Economics

- [Constant vs actual dollar; inflation-free rate on loan](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Aconstant-actual-dollar-bike-loan) — Engineering Economics, chapter 8, asked 2×
- [Inflation, effects, inflation-free rate](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Adefine-inflation-effects-implied-rate) — Engineering Economics, chapter 8
- [Car loan interest rate and lump sum at year 3](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Acar-loan-installments-lump-sum-year3) — Engineering Economics, chapter 2
- [PW with differential inflation rates](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Apw-constant-dollars-differential-inflation) — Engineering Economics, chapter 8
- [Simple vs compound interest; number of deposits](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Asimple-vs-compound-deposits-20-lakh) — Engineering Economics, chapter 2
- [Choose machine under 5% inflation](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Amachine-xy-inflation-5-percent) — Engineering Economics, chapter 8

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