MACROECON question... 2500?

Question

Suppose that last year you borrowed $100 at 5 percent interest to purchase a $100 pair of nike shoes. this year you repaid the bank with interest. If the inflation rate was 10 percent last year, your purchase of shoes would:
a. make you an inflation winner as you saved $5 on the shoes
b. make you an inflation loser as you paid $5 more than you should have for the shoes.
c. not be affected at all by the inflation rate.
d. be taxed according to COLA adjustments.
e. make you an inflation loser because of bracket creep.

Explain/show answer to collect points.

Answer 1

The answer is a. Had you waited to purchase the shoes this year, they would now cost 10% more, since inflation is defined as an increase in the price level. So, you would have paid $110. Instead you paid $105, the principal of $100 and $5 interest. Thus, you saved $5 and were an inflation winner.

Answer 2

The relationship between Inflation and interest rates can be explained like this ;
-Inflation means increase on consumer prices.
- Interest rates directly affect the credit market(loans).
-Higher interest rates makes borowing more costly,but profitable for creditors, banks.
-But as interest rates drop, consumer spending increases bcoz lower yields on savings are discouraging.

Now how does inflation affect borrowers and creditors?

Your scenario;
You are about to repay the bank total $105 inclusive the 5% interest in the proposal of last year.

If last year inflation rate was 10%, it ate away at the bank's gain on interests, bcoz inflation reduce purchasing power,thus reduce returns on the banks loan. The debtor (you) benefits from interest rate declining, and the bank loses bcoz of the difference between NOMINAL interest rates and REAL interest rates.

**NOMINAL interest rates=growth rate of the banks loan
**REAL interest rates = the growth of the purchasing power

Therefore the REAL rate of interest is calculated
=> NOMINAL rate - INFLATION = 5% -10% = -5% !

*********Answer a.******

This means you keep the $5 back in your pockets! And the banks purchasing power has fallen from inflation