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homework3fall2007 - 1 Economics 102 Fall 2007 Homework#3...

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Economics 102 Fall 2007 Homework #3 Problem 1. In 2014, Bill wants to borrow $1000 from Steve (who owns Orange Inc.) to found his company Macrosoft. Bill offers to pay Steve back principal and interest in 2015. They both expect the inflation to be 5% for the year. Steve is willing to make the loan provided he earns a real interest rate of 10% on this loan (he doesn’t believe Macrosoft could make much money). (a) How much will Bill need to pay Steve back in a year in order for Steve to be willing to lend him the money? (b) After their agreement, suppose the actual inflation rate in 2015 is only 3%. Who is the winner given the loan agreement outlined in part (a)? (Hint: the winner is that individual who gets more than they expected when they made the loan agreement.) What is the gain equal to in real terms using 2014 as the base year? (c) Suppose the actual inflation rate in 2015 is 7%. Who is the winner given the loan agreement outlined in part (a)? What is the gain equal to in real terms using 2014 as the base year?
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