Question

3) (15 points) A local credit union pays a market interest rate of 5% per year for long-term deposits. The current inflation rate is 2% per year. a) (5 points) If I invest some money in a long-term fund at the credit union, what is the real (inflation- free) interest rate I will be earning? b) (10 points) I open a new account today, deposit $10,000, and do not expect to make any deposits or withdrawals for the next 5 years. What will be my account balance at the end of 5 years expressed in (i) Actual or Then-current dollars (ii) Real or Constant dollars

Answer 1

Solution

a) Real interest rate = Nominal Interest Rate - Inflation Rate

= 5 - 2 i.e., 3% per year

b.(i) Actual / or then current dollars

Time = 5 years ; Principal = $10,000 ; Nominal Rate of interest (r) = 5 % per year ; Maturity Amount = ?

Amount =10,000 ((1+ (r/100)) ^ n)

= 10,000 ( 1.05 ^ 5) i.e., $12,762.81

(ii) Real / Constant dollars

Here the calculation remains the same but instead of the Nominal interest rate we need to take the real interest rate into the consideration

   Amount =10,000 ((1+ (r/100)) ^ n)

= 10,000 ( 1.03 ^ 5) i.e., $ 11,592.74

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