Question

Suppose Amy is an avid reader and buys only mystery novels. Amy deposits $3,000 in a bank account that pays an annual nominal interest rate of 5%. Assume this interest rate is fixed—that is, it won't change over time. At the time of her deposit, a mystery novel is priced at $10.00.

Answer 1

Calculate the initial deposits of Amy in terms of mystery novels, as follows: $3,000 $10 = 300 mystery novels Therefore, initially, the purchasing power of Amy's $3,000 deposit is 300 mystery novels. It is given that the interest rate is 5%. Real interest rate is calculated using the following formula: Real interest rate = Nominal interest rate - Inflation rate Calculate the real interest rate as follows: Real interest rate (when inflation rate is 0%) = 5%-0% = 5%

Real interest rate (when inflation rate is 5%) = 5%-5% = 0% Real interest rate (when inflation rate is 8%) = 5%-8% = -3% Calculate the number of novels that can be purchased after a year as follows: Number of novels (when inflation rate is 0% = 300 + 5 % of 300 = 300 +0.05(300) = 315 Number of novels (when inflation rate is 5% = 300 +0% of 300 = 300 Number of novels (when inflation rate is 8%) = 300-3 % of 300 = 300 – 0.03 (300) = 291

Therefore, fill the table as follows: Annual Inflation Rate 0% 5% 8% 315 300 Number of novels Amy can purchase after one year 291 Real Interest Rate 5% 0% -3% Now, when rate of inflation is less than the interest rate on Amy's deposits, real interest rate is positive, and the purchasing power of money has increased. Thus, when the rate of inflation is less than the interest rate on Amy's deposit, the purchasing power of her deposit increases over the course of the year.