Question

Consider an individual who lives for two periods, earns a nominal income of $1000 in each period, and has zero initial and terminal assets. The nominal interest rate, R, on dollar loans is 15%, and the expected rate of inflation, πe, between the two periods is 10%. Assume that the price level in the first period is 1.

A. What is the real value of period 1 income?

B. What is the maximum amount of dollars that could be borrowed in period 1? Find the real value of this amount and add it to the real value of period 1 income to see the maximum amount of (real) consumption possible in period 1.

C. What is the price level in period 2? What is the real value of period 2 income?

D. What is the maximum amount of dollars that can be obtained in period 2 by saving in period 1? Find the real value (in period 2) of this amount and add it to the real value of period 2 income to see the maximum amount of (real) consumption possible in period 2.

Answer 1

A. Real value of period 1 income = 1000/1 = $1000

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B. Maximum amount of dollars that could be borrowed in period 1 = 15% x 1000 = $150

Real value of this amount = 150/1 = $150

Maximum amount of (real) consumption possible in period 1 = 1000 + 150 = $1150

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C. Price level in period 2 = 1.1 (due to inflation of 10%)

Real value of period 2 income = 1000/1.1 = $909.09

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D. Maximum amount of dollars that can be obtained in period 2 by saving in period 1 = 1000 + 150 = $1150 (assuming the individual saves all income at 15%)

Real value (in period 2) of this amount = 1150/1.1 = $1045.45

Add it to the real value of period 2 income = $909.09 + $1045.45 = $1954.54

Maximum amount of (real) consumption possible in period 2 = $1954.54