The Impact of Inflation on Purchasing Power Analysis
How does inflation affect the purchasing power of Devon's deposit over time? What is the relationship between inflation rate and real interest rate in this scenario?
Scenario:
Devon, a fashionista who only buys denim jackets, deposits $4,000 into a savings account with a fixed annual nominal interest rate of 10%. On the day of the deposit, a denim jacket costs $20.00.
Annual Inflation Rate:
0%, 10%, 13%
Number of Jackets Devon Can Purchase after One Year:
Initially: 200 jackets
Real Interest Rate:
0%, 10%, -3%
Final answer:
Initially, Devon can purchase 200 jackets. After one year, depending on the inflation rate, Devon can purchase 220 jackets if there's no inflation, 200 jackets if the inflation rate is 10%, and 194 jackets if the inflation rate is 13%. The purchasing power falls over the year when the inflation rate is greater than the interest rate.
Analysis of Inflation Impact:
Initially, Devon's $4,000 deposit can purchase 200 denim jackets ($4,000 / $20.00 = 200 jackets). When the inflation rate is 0%, the price remains $20.00, allowing Devon to buy 220 jackets after one year with a real interest rate of 10%. However, in scenarios of 10% and 13% inflation, the purchasing power decreases to 200 jackets and 194 jackets respectively. The real interest rate reflects the difference between the inflation rate and the interest rate, affecting Devon's purchasing power.
Detailed Explanation:
Devon's initial deposit of $4,000 allows her to buy 200 denim jackets at $20.00 each. As the inflation rate varies over time, the price of a jacket changes accordingly, impacting the number of jackets she can purchase after one year.
When inflation remains at 0%, Devon's deposit grows by 10% due to interest, enabling her to purchase 220 jackets at a price of $20.00 each. The real interest rate in this case is 10%, indicating a favorable purchasing power increase.
However, when inflation rises to 10%, the price of a jacket becomes $22.00, leading Devon to afford only 200 jackets with her now $4,400 deposit. The real interest rate drops to 0% as inflation catches up with interest, maintaining purchasing power.
In the scenario of 13% inflation, the jacket price jumps to $22.60, resulting in Devon being able to buy approximately 194 jackets with her $4,400 deposit. Here, the real interest rate turns negative at -3% as inflation overtakes the interest rate, diminishing her purchasing power.