Question

It is estimated that 100,000 bags of cement will be needed in total for a building project. Cement costs at GHS 30 today. It is expected that in one year the price will be GHS 39 per bag to reflect inflation. A bank is willing to lend you money to buy all the cement you need today. However, in one year, you will pay the bank enough money to buy back 110,000 bags.

i) What is the real return to the bank if you are able to meet the condition?

ii) What is the nominal return to the bank?

iii) Show that the Fisher effect holds in Ghana.

Answer 1

Solution:

i)Calculation of real rate of return

Real rate of return does not consider the inflation effect.

Money lend by bank=GHS30*100,000=GHS3000,000

If inflation is not consider,Money to be returned back=GHS30*110,000=GHS3300,000

Real rate of return to the bank=[(GHS3300,000-GHS3000,000)/GHS3000,000]*100

=[GHS300,000/GHS3000,000]*100

=10%

ii)Calculation of nominal return to the bank

Nominal return=Real rate of return+Inflation

It means nominal return include the effect of inflation.Thus nominal return to the bank is calculated as follow;

Money lend by bank=GHS30*100,000=GHS3000,000

If inflation is consider,Money to be returned back=GHS39*110,000=GHS4,290,000

Nominal return to the bank=[(GHS4,290,000-GHS3000,000)/GHS3000,000]*100

=43%

iii)Fisher equation is concept that describe the relationship between nominal and real rate of return under the effect of inflation.

As per fisher equation;

Real rate of return+Inflation rate=Nominal rate of return

Inflation rate of return to bank=[(GHS39-GHS30)*110,000 bags]/GHS3000,000]*100

=[GHS990,000/GHS3000,000]*100

=33%

In the given case;

Real rate of return+Inflation rate=Nominal rate of return

10%+33%=43%

Thus,fisher effects hold in Ghana.