Question

Situation: Mrs. Theodora deposited $3000 into her bank account today. The current real interest rate is 4%, Inflation rate will be 8% over the next year as expected. What nominal rate would Mrs. Theodora demand from the bank over the next year? How much cash will she have at the end of 1 year? If she was saving to buy a sewing machine that currently sells for $3,250 will she have enough cash to buy it after 1 year? Please answer through proper calculations.

Answer 1

Real Rate of Return = [(1+Nominal Rate of Return)/(1+Inflation Rate)]-1

Therefore,

0.04 = [(1+N)/(1+0.08)]-1

1.04*1.08 = 1+N

Therefore, Nominal Rate of Return = 1.1232-1 = 0.1232 = 12.32%

Cash at the end of 1 year = Amount Deposited*(1+Nominal Return) = 3000*(1+0.1232) = $3369.6

Price of sewing machine after 1 year = Current Price*(1+Inflation Rate) = 3250*(1+0.08) = $3510

As, Price of sewing machine will be MORE than money at the end of year 1, She will NOT have enough cash.