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Suppose you have $1,000, which you can put in two different types of accounts at a bank. One account pays interest of 8 percent per year; the other pays interest of 2 percent per year plus the rate of inflation. Calculate the real return you will receive after one year if the inflation rate is 5 percent. Which account will you choose if you expect the rate of inflation to be 8 percent? Why?

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Answer:

In both cases the second bank offers better conditions.

Explanation:

Giving the following information:

Suppose you have $1,000, which you can put in two different types of accounts at a bank.

We need to use the following formula:

FV= PV*(1+i)^n

A) Interest rate= 8%

i) inflation= 5%

i= 8 - 5= 3%

FV= 1000*(1.03)= $1030

ii) Inflation= 8%

i= 0%

FV= 1000

B) Interest= 2% + inflation

i) i= 7%

FV= 1000*1.07=1070

ii) i= 10%

FV= 1000*1.10= 1100

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