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16 January, 15:30

Luigi is willing to lend Klaus $5,000 for one year at a nominal rate of interest of 7%. Both Luigi and Klause expect the rate of inflation to be 2% in the next year. How much additional purchasing power will Luigi have in one year?

A. $5,250

B. $350

C. $250

D. $5350

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Answers (1)
  1. 16 January, 15:58
    0
    Option (C) $250

    Explanation:

    Data provided in the question:

    Amount willing to lend i. e Loan = $5,000

    Nominal rate of interest = 7%

    Rate of inflation = 2%

    Now,

    Purchasing power in one year = Loan * (1 + Real interest rate)

    = Loan * [ 1 + (Nominal rate of interest - Rate of inflation) ]

    = $5,000 * [ 1 + (7% - 2%) ]

    = $5,000 * [ 1 + 5% ]

    = $5,000 * [ 1 + 0.05 ]

    = $5,250

    Hence,

    Additional purchasing power in one year = $5,250 - $5,000

    = $250

    Option (C) $250
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