Suppose that you had savings deposited in an account at an interest rate of 5 pe

Question

Suppose that you had savings deposited in an account at an interest rate of 5 percent and your father told you that he earned 10 percent interest 20 years ago. Which of you is getting a better return? Is that all the information you need? Suppose that the inflation rate in the United States was 12 percent 20 years ago and is 3 percent now. Does this information change your answer? Be sure to use the concept of the real interest rate in your answer. 0 Suppose I lend my friend Peter $100 for one year, and he agrees to repay me with interest. We each have an expectation that the inflation rate over the coming year will be 5 percent, and so we agree that he will pay me back at a nominal rate of 7 percent interest. What real rate of return do I expect to receive? What happens if inflation turns out to be 8 percent over the year? Who is made better off and who is made worse off?

Explanation / Answer

Situation 1: I am getting interest rate of 5% currently

Situation 2: My father was getting interest rate of 10% 20 years ago.

Based on above situations, it is not clear who is getting a better return as there is insufficient knowledge about the compounding interval, inflation, whether my investment is getting compounded at the end of each period and for my father – whether the investment was getting compounded at the beginning of each period, etc.

Now,

Say the inflation rate 20 years ago was 12% so the effective interest rate would be 10%-12% = -2%

Say the inflation rate now is 3% so the effective interest rate would be 5%-3% = 2%

Clearly if I ignore the effects of compounding and all other effects, certainly I am better off by making 2% return as against my father whose return was in fact negative in real terms.

Moreover, if

Nominal rate = 7%. Inflation rate = 5%. Therefore, the real rate of return would be 7%-5% = 2%. Certainly, I am better off compared to Peter in real terms & if

Nominal rate = 7%. Inflation rate = 8%. Therefore, the real rate of return would be 7%-8% = -1%. In this case, Peter is better off in real terms

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.