Question

Suppose Teresa is a sports fan and buys only baseball caps. Teresa deposits $3,000 in a bank account that pays an annual nominal interest rate of 15%. Assume this interest rate is fixed—that is, it won't change over time. At the time of her deposit, a baseball cap is priced at $15.00.

Initially, the purchasing power of Teresa's $3,000 deposit is

baseball caps.

For each of the annual inflation rates given in the following table, first determine the new price of a baseball cap, assuming it rises at the rate of inflation. Then enter the corresponding purchasing power of Teresa'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 baseball cap. For example, if you find that the deposit will cover 20.7 baseball caps, you would round the purchasing power down to 20 baseball caps under the assumption that Teresa will not buy seven-tenths of a baseball cap.

	Annual Inflation Rate
	0%	15%	18%
Number of Caps Teresa Can Purchase after One Year
Real Interest Rate

When the rate of inflation is less than the interest rate on Teresa's deposit, the purchasing power of her deposit rises/falls/remains the same over the course of the year.

Answer 1

Initially, the purchasing power of Teresa's $3,000 deposit is = 3000/15 = 200 baseball caps.

Deposit after one year = 3000 x (1 + 15%) = $ 3450

	Annual Inflation Rate
	0%	15%	18%
New Price	15	17.25	17.7
Number of Caps Teresa Can Purchase after One Year	230	200	194
Real Interest Rate	15%	0%	-3%

New price = 15 x (1 + inflation rate)

When the rate of inflation is less than the interest rate on Teresa's deposit, the purchasing power of her deposit rises over the course of the year.