Question

Suppose that you are running a business and you need some extra space for one year. Your bank offers you a loan of $100,000 at 0% Interest. You consider borrowing this amount, buying the building, using it for one year, and then selling the building to pay back the loan. Unfortunately, the economy in which you are operating is experiendng deflation at the rate of 10% per year. After one year, you should be able to sell the building for Suppose that owning the building for a year would eam you $5,000. To decide whether or not you will be better off by owning it for one year and then seling it, you sought advice from three different people: (1) Your brother says that you should not buy the building because in one year it will cost you $100,000. (2) Your accountant says that you should definitely buy the building because you can borrow $100,000 at zero interest while the building will generate $5,000 in extra income. Then when you sell it, you will be $5,000 richer. (3) Your bookkeeper says that if you sell the building in a year, you will have to come up with more money to pay off the loan than you will make in extra income. Keeping in mind that the economy experiences deflation at the rate of 10%, who is right? O Your bookkeeper is right, because the extra income you will earn will be less than the cost of owning the building for the year Your brother is correct, because when the nominal interest rate is zero, the cost of a building is its full purchase price O Your accountant is right, because when the nominal interest rate is zero, you do not incur any cost when you take out a loan. Now, suppose you inherited $100,000 in cash from your uncle who had kept it hidden in his mattress. Assuming the

Please explain the working as well.
Thank you

Answer 1

Answer 1) $ 90,000

Since deflation has been set in the Economy, so general price level has been falling, thus value of building will fall by $10,000.

Now MCQ) bookkeeper is correct only, option a)

Bcoz total benefob from owning the building for a year is = $90000 + $ 5000, = $ 95,000

Whereas loan to be repaid = 10,0000, so loss of 5000$

Next MCQ) option b)

Since deflation, so keep the amount with urself , if deposit in bank, hthen , no interest , rather bank will deduct the charges.

Hence keep money in the hands.

Next question)

False

high real interest rate causes firms with money to want to save it rather than invest it because they get a higher return on their money then. Also it will discourage borrowing ,because they will have to pay more on loans relatively.