Suppose Latasha is an avid reader and buys only mystery novels. Latasha deposits

Question

Suppose Latasha is an avid reader and buys only mystery novels. Latasha deposits $2,000 in a bank account that pays an annual interest rate of 20%. You can assume that this interest rate is fixed-that is, it won't change over time. At the time of her deposit, a mystery novel is priced at $10.00. Initially, the purchasing power of Latasha's $2,000 deposit is 50 mystery novels. The price of a mystery novel rises at the rate of inflation. For each of the annual inflation rates in the following table, select the corresponding purchasing power of Latasha's deposit after one year, and enter the value for the real interest rate. Hint: Round your answers down to the nearest mystery novel. For example, if you find that the deposit will cover 20.7 mystery novels, you would round the purchasing power down to 20 mystery novels under the assumption that Latasha will not buy seven-tenths of a mystery novel. When the rate of inflation is less than the interest rate on Latasha's deposit, the purchasing power of her deposit _ over the course of the year.

Explanation / Answer

Initially purchasing power of Latasha = 2000/10 = 200 novels Annual inflation rate = 0% Value of money after 1 year = 2000*1.2 = $2400 No of novels Latasha can purchase = $2400/10 = 240 novels Real interest rate = 20%-0% = 20% Annual inflation rate = 20% Value of money after 1 year = 2000*1.2 = $2400 Price of novel after one year = 10*1.2 = 12 No of novels Latasha can purchase = $2400/12 = 200 novels Real interest rate = 20%-20% = 0% Annual inflation rate = 22% Value of money after 1 year = 2000*1.2 = $2400 Price of novel after one year = 10*1.22 = 12.2 No of novels Latasha can purchase = $2400/12.2 = 196 novel Real interest rate = 20%-22% = -2% When the rate of inflation is less than the interest rate, the purchasing power increases over the course of years

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