Question

Johnny's interest rate on his saving account is 3%3% per year, and inflation is 2.5%2.5% per year. After one year, what would the money in his account buy?

Answer 1

Nominal Rate of Return= 3% ( Interest Rate on Savings Account)

The Savings Account Balance increases by 3% per year, but the purchasing power will not increase by 3%.

This is due to raise in the prices co commodities i.e., Inflasion.

Inflasion = 2.5%

(1+ Nominal Rate) = (1+ Real Growth) ( 1 + Inflasion Rate)

(1 + 0.03) = (1 + X) (1 + 0.025)

(1 + Real Growth) = (1.003) / (1.025)

1 + Real Growth = 0.9785

Real Growth = 1 - 0.9785

Real Growth = 2.146% = 2.15% (approx)

After one year, Johnny can buy 2.15% more worth of commodities from his balance in Savings Account.