2) (20 points) A local credit union pays interest at a rate of 5% per year for l

Question

2) (20 points) A local credit union pays interest at a rate of 5% per year for long-term deposits. The current inflation rate is 2% per year.

a) 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) I open a new account today, deposit $10,000, and do not expect to make any deposits or withdrawals for the next two years. What will be my account balance at the end of two years expressed in

1. Then-current dollars

2. Constant dollars

c) If I decide to withdraw the entire balance in my account and close the account at the end of the two-year period, how much money will I actually get in my hand?

Explanation / Answer

Question 2

(a)

Nominal interest rate = 5%

Inflation rate = 2%

Calculate the real (inflation-free) interest rate -

Real interest rate = Nominal interest rate - Inflation rate

Real interest rate = 5% - 2% = 3%

The real (inflation-free) interest rate is 3 percent.

(b)

(1)

At Then-Current Dollars -

This amount would be calculated at nominal interest rate.

Calculate the amount at the end of the two years -

Amount = $10,000 * (1+0.05)2

Amount = $10,000 * (1.05)2

Amount = $10,000 * 1.1025

Amount = $11,025

The account balance at the end of two years expressed in then-current dollars is $11,025.

(2)

At Constant dollars

This amount would be calculated at real interest rate.

Calculate the amount at the end of two years -

Amount = $10,000 * (1+0.03)2

Amount = $10,000 * (1.03)2

Amount = $10,000 * 1.0609

Amount = $10,609

The balance at the end of two years expressed in constant dollars is $10,609.

(c)

if the person decide to withdraw the entire balance in his or her account and close the account at the end of the two-year period, he or she will get the amount expressed in then-current dollars in hand.

The amount in then-current dollars is $11,025.

So,

The money person will actually get in hand in $11,025.

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