7. Suppose that a consumer is facing following offers: Offer 1: receive today 44

Question

7. Suppose that a consumer is facing following offers:

Offer 1: receive today 4400 euros and receive 2200 euros exactly in one year

Offer 2: receive today 1500 euros and receive 5500 euros exactly in one year

Which offer would the rational person accept if:

a) the nominal annual interest rate is 10% and the expected inflation is 0%.

b) the nominal annual interest rate is 25% and the expected inflation is 0%.

Let’s assume that the choice between these two offers does not affect the offers made for this individual in the future. Suppose also that the interest rate applies both, for lending as well as for borrowing.

Explanation / Answer

(a) Real interest rate = Nominal interest rate - Inflation rate = 10% - 0 = 10%

Present worth, Offer 1 (Euro) = 4,400 + (2,200 / 1.1) = 4,400 + 2,000 = 6,400

Present worth, Offer 2 (Euro) = 1,500 + (5,500 / 1.1) = 1,500 + 5,000 = 6,500

Consumer will choose Offer 2 since it has higher Present Worth.

(b) Real interest rate = Nominal interest rate - Inflation rate = 25% - 0 = 25%

Present worth, Offer 1 (Euro) = 4,400 + (2,200 / 1.25) = 4,400 + 1,760 = 6,160

Present worth, Offer 2 (Euro) = 1,500 + (5,500 / 1.25) = 1,500 + 4,400 = 5,900

Consumer will choose Offer 1 since it has higher Present Worth.

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