Question

Answer the following questions about the (real) inflation tax, assuming that the price level starts at 100.

a. Maria Moneybags keeps $1,000 in her sock drawer for a year. Over the year, the inflation rate is 10%. What was Maria’s reduction in real purchasing power for this year?
b. Maria continues to keep the $1,000 in her drawer for a second year. What is the real value of this $1,000 at the beginning of the second year? Over the year, the inflation rate is again 10%. What was Maria’s reduction in real purchasing power for the second year?

Answer 1

a) $900 after 1 year

b) $810 after 2 years

Step-by-step explanation:

This deals with the time value of money concept. This states that money is worth more today than the same amount is worth sometime in the future. The real purchasing power is the nominal purchasing power discounted back as per the prevailing inflation rate.

For a)

$1000 after one year will be worth 1000 * 0.9 = $900 or a reduction of $100 as 1000 today is worth only 900 after 1 year.

For b)

The inflation rate discounts real purchasing power year over year so after 2 years the real purchasing power will be as follows,

Real purchasing power = 900 * 0.90 = $810 which is discounted by 10% inflation for 2 years.

Hope that helps.