Suppose that you are running a business and you need some extra space for one ye

Question

Suppose that you are running a business and you need some extra space for one year. You bank offers you a loan of $100,000 at 0% interest. You consider borrowing this amount, buying the building, using it for one year, and then selling the building to pay back the loan. Unfortunately, the economy in which you are operating is experiencing deflation at the rate of 10% per year. After one year, you should be able to sell the building for Suppose that owning that owning the building for a year would earn you $5,000. To decide whether or not you will be better off by owning it for one year and then selling it, you sought advice from three different people: (1) Your brother says that you should not buy the building because in one year it will cost you $100,000. (2) Your accountant says that you should definitely buy the building because you can borrow $100,000 at zero interest while the building will generate $5,000 in extra income. Then when you sell it, you will be $5,000 richer. (3) Your bookkeeper says that if you sell the building in a year, you will have to come up with more money to pay off the loan than you will make in extra income. Keeping in mind that the economy experiences deflation at the rate of 10%, who is right? Your brother is correct, because when the nominal interest rate is zero, the cost of a building is its full purchase price. Your bookkeeper is right, because the extra income you will earn will be less than the cost of owning the building for the year. Your accountant is right, because when the nominal interest rate is zero, you do not incur any cost when you take out a loan. Now suppose you inherited $100,000 in cash from your uncle who had kept it hidden in his mattress. Assuming the nominal interest rate is -1%, which of the following options will maximize the amount of cash that you have in one year? Buying the building, because you can earn an additional $5,000 in income if you own the building for one year and then sell it Holding onto your $100,000 in cash Depositing the cash in the bank, because the 10% rate of deflation makes the value of your dollars fall even more rapidly than 1% per year True or False: A high real interest rate will keep firms borrowing to finance investment in capital, but it will not keep firms with cash from investing in capital. True False

Explanation / Answer

$90,000 will be the price of the building

In deflation the prices of assets will fall in the market.

1)B

Book keeper is right, $ 10,000 is lost in deflation, so there is no way we can get that money back.

2) B

As nominal interest is -1%, No one would go to a bank to deposit. They would just hold on to the money

3) False

This is what happened in emerging markets for decades, High real interest rates were responsible for firms not taking loans in countries like India, but rich foreign firms invested in that country anyway.

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