Unformatted text preview: 5. Interest, Inﬂation. and purdlislng power Suppose Terese Is a clnephlle and buys only movie tickets. Terese deposits $3,000 tn a bank acoount that pays an
annual interest rate of 10%, You can assume that this interest rate Is ﬁxedthat is, It won't change over time. At the
time or her deposit, a movie ticket oosts $20.00. Initially, the purchasing power of Tereses $3,000 deposit Is 150 \f movie tickets. The price of a movie ticket rises at the rate of Inﬂation. For each of the annual inﬂation rates In the table below,
select the oorrespondlng purchasing power of Teresa deposit after one year and enter the value for the real Interest
rate. Hint: Round your answers down to the nearest movie ticket. For example, ii you find that the deposit will oover 20.7
movie tickets youd round the purchasing power down to 20 movie tickets under the assumption that Terese will not
buy seventenors or a movie ticket. Annual Inﬂation Rate 0% 10% 12%
Number olTleliets
Teresecan Purchase 155 J 150 f 147 J
meronayear
Reallnterestltate 10% \f 0% \f 2% ‘f When the rate of inﬂation Is greater than the Interest rate on Tereses deposit, the purchasing power of her deposit
Ialls J over the course of the year. Explanation: ﬂan A The Initial value of the deposit Is $3,000 and the Initial pi1oe of a movie ticket ls $20.00. The initial deposit therefore
has the power to purchase 150 tickets. In the absence of any Inﬂation, the price of a movie ticket remains at $20.00 after one year, while the value of
Terese: deposit Ineleases to $3,000 x (1 + 0.10) = $3,300. With zero inflation' the purchasing power ofthe
oneyearald deposit rises to 165 tickets. Generally, when the rate of inﬂation is lower than the interest late on a
deposit, Ihe purchasing powerof the deposit rise over time. The real Interest rate Is approximately equal to the nominal Interest rate minus the Inflation rate. When the Inﬂation
late ls zero, the real Interest rate Is 10%  0% = 10%. When the rate of inflation Is 10% per year, the price of a movie ticket rises to $20.00 X {1 + 0.10) = $22.00. The
value ofthe deposit rises by 10% over the course ofthe year as well. Aﬂzer one year, the deposit has are power to
purchase $3,300 I $22.00 per movie ticket = 150 tickets. If the Inﬂation rate is equal to the interest rate on the
deposit, the real Interest rate Is one and the purchasing power ofthe deposit does not mange over time. At a 12% annual rate of Inflation, the price of a movie ticket rises to $20.00 1(1 + 0.12) = $22.40. The value ofthe
deposit rises by only 10%. After one year, the purchasing power of the deposit Is approximately 1.47 tickets (=
$3,300 I $22.40 per movie ticket). The 2% decrease in the purchasing power of die deposit oomrs because the
nominal Interest rate [10%) Is less man the inﬂation rate (12%), resulting In a real Interest rate of 2% (= 10% 
12%). ...
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 Fall '08
 HannahHolmes
 Economics

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