Interest Inflation and purchasing power Interest inflation a

Interest, Inflation, and purchasing power

Interest, inflation, and purchasing power Suppose Stella is a sports fan and buys only baseball caps. Stella deposits $2,000 in a bank account that pays an annual interest rate of 10%. You can assume that this interest rate is fixed-that is, it won\'t change over time. At the time of her deposit, a baseball cap is priced at $10.00. Initially, the purchasing power of Stella\'s $2,000 deposit is 200 baseball caps. The price of a baseball cap rises at the rate of inflation. For each of the annual inflation rates in the following table, select the corresponding purchasing power of Stella\'s deposit after one year, and enter the value for the real interest rate.

Solution

Stella\'s Initial deposit was $ 2000

Annual interest rate is 10%

So after ! year :

When inflation is 0% the price of caps remains the same where as Stella\'s money increases by 10%.

Now Stella have $ 2200 by which she can buy (2200/20)=110 caps.

The real interest rate remains 10%,

As per the law real interest states= (actual interest rate - inflation rate of a given time).

When inflation rises to 10% the price of caps become $202 and Stella\'s money remains $2200.

Now Stella can buy (2200/22)= 100 caps.

The real interest becomes (10-10)= 0%.

When inflation rises to 12% the price of the caps becomes $22.40, while Stella\'s money remain $2200.

Now Stella can buy (2200/22.40)= 98 caps.

The real interest rate increases by 2%.

The purchasing power of her deposit falls over the course of the year.