Question

Suppose you deposit $1000 into a bank account earning 2% interest for the next year. If the inflation rate over the next year is 1%, then what can be said about the 2% return you have earned on your deposit?

a) The $1020 you will have in one year will purchase less than $1000 would purchase today.

b) The $1020 you will have in one year will purchase more than $1000 would purchase today.

c) The $1020 you will have in one year will purchase the same amount as $1000 would purchase today.

d) None of the above are correct.  

Answer 1

ANSWER

CORRECT OPTION: Option (b) : The $1020 you will have in one year will purchase more than $1000 would purchase today.

EXPLANATION

• Given that the nominal rate earned is 2% annual and the Inflation rate prevailing is 1% annual. This means that our Real rate earned is still Positive 1% annual.
• This means that even after one year when prices of everything will get increased by 1% due to the Inflation, we will still be having 1% extra with us {ie . our Real Rate earned} .
• So lets understand it with an Example :

- Price of Product "X" today be : $1000

- Amount available with us : $1000

- quantity of product X that we can buy today = $1000 / $1000 = 1

Now after 1 year

- Price of Product "X" today be : $1000 (1.01) = $1010

- Amount available with us : $1000 (1.02) = $1020

- quantity of product X that we can buy today = $1020 / $1010 = 1.01

proved that $ 1020 after 1year will buy more that what $1000 buy today.