Question

4. Interest, inflation, and purchasing power Suppose Caroline is an avid reader and buys only mystery novels. Caroline deposits $4,000 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 Initially, the purchasing power of Caroline's $4,000 deposit is mystery novels. For each of the annual inflation rates given in the following table, first determine the new price of a mystery novel, assuming it rises at the rate of inflation. Then enter the correspondlig purchasing power of Caroline's deposit after one year in the first row of the table for each inflation rate. Finally, enter the value for the real interest rate at each of the given inflation rates. Hint: Round your answers in the first row down to the nearest mystery novel. For example, if you find that the deposit will cover 20.7 mystery novels, you would round the purchasing power down to 20 mystery novels under the assumption that Caroline will not buy seven-tenths of a mystery novel Annual Inflation Rate 0% 5% 8% Number of Novels Caroline Can Purchase after One Year Real Interest Rate When the rate of inflation is greater than the interest rate on Caroline's deposit, the purchasing power of her deposit course of the year over the

Answer 1

Purchasing power is basically the nominal income divided by price of the product. Initially the amount of depos is 4000 dollars and the price of the novel is a $10 This means the purchasing power is 4000 / 10 = 400 mystery novels When the annual inflation rate is 0%, the nominal interest rate and real interest rate are equal to each other an therefore there is increase in purchasing power. Real interest rate is 5%. Number of novels purchased = 4000(1+5%)/(10(1+0%)) = 420 When the annual inflation rate is 5%, the nominal interest rate and inflation rate are equal to each other an therefore there is no change in purchasing power. Real interest rate is 0%. Number of novels purchased = 4000(1+5%)/(10(1+5%)) = 400 When the annual inflation rate is 8%, there is a decline in purchasing power. Real interest rate is -3%. Number of novels purchased = 4000(1+5%)/(10(1+8%)) = 388 When the rate of inflation is greater than the interest rate on deposit, purchasing power declines over time