5. Interest, inflation, and purchasing power
Suppose Neha is an avid reader and buys only mystery novels. Neha deposits $3,000 in a bank account that pays an annual nominal interest rate of
5%. Assume this interest rate is fixed---that is, it won't change over time. At the time of her deposit, a mystery novel is priced at $10.00.
Initially, the purchasing power of Neha's $3,000 deposit is mystery novels.
For each of the annual inflation rates given in the following table, first determine the new price of a mystery novel, assuming it rises at the rate of
inflation. Then enter the corresponding purchasing power of Neha's deposit after one year in the first row of the table for each inflation rate. Finally,
enter the value for the real interest rate at each of the given inflation rates.
Hint: Round your answers in the first row down to the nearest mystery novel. For example, if you find that the deposit will cover 20.7 mystery
novels, you would round the purchasing power down to 20 mystery novels under the assumption that Neha will not buy seven-tenths of a mystery
novel.
Number of Novels Neha Can Purchase after One Year
Real Interest Rate
Annual Inflation Rate
0%
5%
8%
%
%
%
When the rate of inflation is equal to the interest rate on Neha's deposit, the purchasing power of her deposit
over the course
of the year.
