3.8. Inflation

Question 1

Inflation…

Answer 1

Erodes the purchasing power of money.

AER and EAR are nominal interest rates, they do not account for inflation. (The real interest does).

Question 2

Inflation equation…

Answer 2

1 + real interest rate = (1 + nominal interest rate) / (1 + inflation rate).

Question 3

Inflation and present values…

Answer 3

Inflation does not affect present value.

This is because present values are discounted.

Question 4

A savings account pays 5% per annum and inflation is at 2%. What is the real interest rate…

Answer 4

1 + real interest rate = (1 + nominal interest rate) / (1 + inflation).

(1 + 0.05) / (1 + 0.02) = 1.029412

= 2.94%.

Question 5

You’re owed £100 and your friend will pay you in one year.

The nominal interest rate is 10%.

Inflation is expected to be 7%. Does this change the previous answer?

Answer 5

PV = 100 / (1+0.10) = £90.91.

Real cash flow = nominal cash flow / 1 + inflation
= 100 / (1.07) = £93.46

Real interest rate = 1+0.10/1+0.07 = 2.80%.

PV = 93.46/(1+0.028) = £90.91.