[Anonymous]

Does anyone know how the purchasing power of $1,800 was calculated in this problem? The provided answer does not provide a calculation. Thanks for your help.

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Assume that you borrow $2,000 from a bank and the loan has an 8% annual percentage rate. The loan is to be paid back at the end of 12 months. If the inflation rate during the year was 10%, then:

Correct A.

the dollars that you repay will have less purchasing power than those you borrowed from the bank.

B.

the real rate of return the bank receives on the loan will be greater than was originally expected.

C.

you will actually be paying the bank back fewer dollars than you borrowed.

D.

the inflation will cause income to be redistributed from you to the bank.

ANSWER:

You are correct, the answer is A.

You have borrowed $2,000 from the bank and the purchasing power of those dollars at the end of the year with a 10% rate of inflation would be $1,800. In this specific instance, even if you add the interest the bank would earn ($160), the purchasing power of the money they receive would be less than the amount lent.