Using the values of r and i in exersice that i post before t

(Using the values of r and i in exersice that i post before the last exersice) suppose Smith borrows 100000 for a year at i=.10, and buys 100000 units of a certain item that haas a current cost of 1 per unt.Suppose the price of this item is tied to the rate of inflation(r=.15). One yea from now Smith sells the items at the inflated price. What is this net gain on this transaction? (This illustrates that during items when inflation rates exceed interest rates, there is great incentive to borrow at the negative real rate of interest.This demand by borrowers is a factor in the invenable correction that leads to the interest rate becoming larger than the inflation rate)

Solution

Smith borrows by paying 10% interest.

Thus, payment made by smith at the end of the year = 100,000( 1 + 0.10) = 110,000.

He buys items at cost of 1 / unit. The price rises to 1 ( 1 + 0.15) = 1.15 / unit

Thus, Amount received by smith on selling the items = 1.15 * 100,000 = 115,000

thus, net profit = amount received - amount paid

=> 115,000 - 110,000

= 5,000

Thus, if interest rates < inflation rates, we have an incentive to borrow money.