Interest, Inflation, and Purchasing Power Analysis
Understanding Devon's Deposit and Purchasing Power
Suppose Devon is a fan of young-adult fiction and buys only young-adult books. Devon deposits $4,000 into a savings account that pays an annual nominal interest rate of 5%. This interest rate is fixed and will not change over time.
Initial Purchase Power Calculation
On the day Devon makes her deposit, a young-adult book costs $10.00. Therefore, Devon's $4,000 deposit has an initial purchasing power of 400 young adult books.
Impact of Inflation Rates on Purchasing Power
For each annual inflation rate provided in the table:
- 3% Inflation Rate: New book price = $10.30, Purchasing power after one year = 388 books, Real interest rate = 2%
- 5% Inflation Rate: New book price = $10.50, Purchasing power after one year = 380 books, Real interest rate = 0%
- 8% Inflation Rate: New book price = $10.80, Purchasing power after one year = 370 books, Real interest rate = -3%
Final Answer
Devon's initial deposit of $4,000 at a fixed annual nominal interest rate of 5% translates to a purchasing power of 400 young-adult books.
Explanation
Devon's deposit of $4,000 into a savings account at a fixed annual nominal interest rate of 5% yields an initial purchasing power of 400 young-adult books, based on the book price of $10.00 at the time of deposit.
As inflation affects the prices, Devon's purchasing power changes accordingly. It showcases how inflation impacts both the overall cost and purchasing power of Devon's deposit over time.
Understanding how inflation and interest rates play into the purchasing power of a deposit is crucial for financial planning and decision-making.
How does inflation impact Devon's purchasing power over time based on the given scenarios? What is the significance of the real interest rate in determining Devon's effective interest earnings? Inflation erodes Devon's purchasing power, reducing the number of books she can buy with her deposit as prices increase. The real interest rate reflects the actual return Devon earns on her deposit after accounting for inflation. When the real interest rate is negative, Devon's effective interest earnings are lower due to the impact of inflation on her purchasing power.