Question

You loaned $100 to a friend for one year at a nominal rate of interest of 3 percent. Inflation during that year was 2 percent. How much did the purchasing power of your money change (an increase is positive and a decrease is negative)?

A) increased by 1 percent.
B) decreased by 1 percent.
C) increased by 5 percent.
D) decreased by 5 percent.

Answer 1

The purchasing power of your money decreased by 5 percent due to inflation.

Step-by-step explanation:

The inflation rate of 2 percent reduced the purchasing power of your money by 2 percent. Therefore, the answer is option D) decreased by 5 percent. Here's how:

When your friend repays the loan after one year, the money you receive will have lost value due to inflation. The nominal interest rate of 3 percent will not be enough to compensate for the loss in purchasing power caused by inflation. As a result, the real rate of return will be negative, indicating a decrease in the purchasing power of your money.