Question

4. You just deposited $3,500 into a bank account and the current real interest rate is at r = 2% and inflation is expected to be te = 3% over the next year. (a) What nominal interest rate, i, from the bank would you require? (b) How much money will you have at the end of one year? (c) How much money will you have at the end of two years? (d) If you are saving up to buy a used car in three years that will cost you $4, 025; will you have enough money to buy it?

Answer 1

a) Nominal rate of interest = real interest rate + rate of inflation (expected) = 2% + 3% = 5%

b) Use FV = PV * (1 + i)^n to get FV = 3500*(1 + 5%)^1 = $3,675

c) Now n = 2 and so FV = 3500*(1 + 5%)^2 = $3,858.75

d) In three years you will be able to accumulate 3500*(1 + 5%)^3 = $4,051.69.

This is enough for buying a used car at $4,025