Question

1 Inflation and interest Suppose you deposit $100 in an account that promises 10% nominal interest. 1. In the next period, how many dollars do you have? 2. If the price level rises from 1 to 1.05. what is the increase in the goods value in the next period, i.e. what is the increase in value using first period dollars. 3. What is the real interest rate? 4. Show how this relates to the Fisher Equation

Answer 1

a. Calculate the amount of money available in the next period as follows: FV = Depositx(1+r) = 100*(1+0.1) = $110 Therefore, the amount of money available in the next period is $110 The increase in value of the goods, using first period dollars, is 5%, that is, 1.05–1=0.05=5% Calculate the value of the goods in next period as follows:

Value of the goods in next period =100 x( Nominal Interest Rate - Inflation Rate) Value of the goods in next period =100 x 5% Value of the goods in next period = 105 Calculate the real interest rate as follows: 105-100 Real Interest Rate =- 100 Real Interest Rate = 100 Real Interest Rate = 5% Therefore, real interest rate is 5% According to the fisher equation,

Nominal Interest Rate = Real Interest Rate + Inflation Rate Nominal Interest Rate =5%+5% Nominal Interest Rate = 10% which is true Hence, proved.