2. $1,000/$1,050/$990/$1,040 3. 1% less/5% more/1% more/4% more/4% less/5% less

Question

2. $1,000/$1,050/$990/$1,040

3. 1% less/5% more/1% more/4% more/4% less/5% less

4. real/nominal

2. The opportunity cost of holding assets as money Aa Aa Suppose you have been told that the opportunity cost of holding wealth as money is determined by the interest rate, but you aren't sure whether this refers to the real interest rate or the nominal interest rate. Suppose the inflation rate is stable at 1%, and you currently have $1,000 in a non-interest-bearing checking account. Consider the decision of whether to hold wealth as money or as an interest-earning asset that pays a nominal rate of 5%. If you hold wealth as an interest-earning asset, you will have $1,040 in wealth at the end of the year. If you hold the wealth as money, you will have $990 in wealth at the end of the year. Holding wealth as an interest-earning asset therefore gives you 5% more purchasing power than you would have if you held the wealth as money. This illustrates that the relevant interest rate for calculating opportunity cost of holding wealth as money is the rea nterest rate. Now consider the decision of whether to spend your wealth today or hold it as an interest-earning asset to spend in a year. Again, assuming inflation is stable at 1%, the purchasing power of $1,000 held as an asset with a nominal rate of 5% will be Holding wealth as an interest-earning asset therefore gives you year compared to the purchasing power you have if you spend it today. This illustrates that the relevant interest rate for calculating opportunity cost of spending money today as opposed to holding wealth as an interest-earning asset for future spending is the in one year, compared to the in purchasing power you have if you spend it today. purchasing power if you spend it in a interest rate.

Explanation / Answer

$1040…$1040 because @5% interest the earnings will be $1050 but with an inflation rate of 1%, $1000 will become as: 5% of 1000 is ($50) – 1% of $1000 ($10) = $1040 $1000………$1000 in purchasing power today as Inflation will reduce the value after 1 year. 4% more purchasing power……. because gain of 5% on $1000 and sacrifice of 1% on $1000 will result in 4% more purchasing power if we spend that after a year. Real interest rate.

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