Real and nominal rates of interest
Zane Perelli currently has $100 that he can spend today on polo shirts costing $25 each. Alternatively, he could invest the $100 in a risk-free U.S. Treasury security that is expected to earn a 9% nominal rate of interest. The consensus forecast of leading economists is a 5% rate of inflation over the coming year.
a. How many polo shirts can Zane purchase today?
b. How much money will Zane have at the end of 1 year if he forgoes purchasing the polo shirts today?
c. How much would would you expect the polo shirts to cost at the end of 1 year in light of the expected inflation?
d. Use your findings in parts b and c to determine how many polo shirts (fractions are OK) Zane can purchase at the end of year 1. In percentage terms, how many more or fewer polo shirts can Zane buy at the end 1 year?
e. What is Zane's real rate of return over the year? How is it related to the percentage change in Zane's buying power found in part d? Explain.