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lectur4-page13 - compensate for inflation You will need to...

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Now, if you expected inflation to be 10 percent from today until one year from now, what nominal (market) interest rate would you demand in order to get the 5 percent real rate of interest that you want, assuming there is no risk associated with the transaction? If you naturally responded 15 percent, we are making progress!! If you did not quickly conclude 15 percent, remember that inflation erodes the purchasing power of your money over time. To get the 5% real rate of interest that you want, someone would have to be willing to pay you an extra 10 percent to
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Unformatted text preview: compensate for inflation. You will need to get at least a 15 percent nominal rate because inflation will eat up 10 percent of the value of your money over the year. After inflation, the value of your money would have only increased 5 percent over the year, the real rate of interest in this example. 10% inflation + 5% real interest rate = 15% interest rate required with no risk. $1.00 today * (1+ interest rate required) = 13 $1.00 today * 1.15 = $1.15 one year from today, $.10 of this lost to inflation....
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