[Anonymous]

I can’t seem to wrap my head around the question below.
Can someone please explain it?

Answer is C

A lender and a borrower signed a contract for a $1,000 loan for one year. The lender asked the borrower to pay 3% interest. Inflation occurred and prices rose by 2% over the next year. The borrower repaid $1,030. What is the amount worth in real terms, after inflation?
A. $1,050.60
B. $1,009.80
C. $1,019.80
D. $1,060.90

[Larry]

The way I am seeing this is that they signed a contract and the lender is expecting to make $30 profit in interest right. So, what happens is that the lender wasn't expecting the inflation to rise 2% in that same year. Now, that $30 profit drops to $10 because prices rise 2% ($1000 x 1.02) = $1020 That's not all though. Because the lender received $1030, you need to adjust for inflation so ($1030/1.03) = 1009.80. After inflation, $1030 is worth 1009.80 but you also have to include the $10 profit so it equals to $1019.80.

I hope I explained it well enough. I'm sure someone else will chime and and explain it better.

What was Becker's explanation?

REG - 82
FAR - 78
BEC - 76
AUD - 8/27/16

[Anonymous]

@papogator24 sorry the answer was (b) NOT (c). I copied this question from online and they had the choices mixed up. The correct answer is

(B) $1,009.80.

Becker says:

The $1,030 amount repaid is readily adjusted for the 2% inflation by dividing it by a factor of 1.02 ($1,030/1.02=$1,009.80), which is 1 plus the 2% inflation rate. Remember inflation reduces purchasing power and will reduce the valuation of a transaction.

Why are we dividing by 1.02?

[Larry]

You're dividing by two because of the cost of inflation. The contract is locked in at 3%, however, it's not adjusted with the inflation. So to get the real value of $1030, you have to divide against the inflation.

REG - 82
FAR - 78
BEC - 76
AUD - 8/27/16

[Anonymous]

thanks @papogator24

[Author]

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