Julio borrows $250 from Ricky. Ricky wants to make a 5% real return on his money, so they both agree on a 5% interest rate paid next year. Both don't anticipate the 5% inflation next year. In this case
A) Ricky is better off.
B) Julio will pay $15 a year from now on.
C) Julio is better off.
D) Ricky will receive more than 5% of real rate of return a year from now.

Question

Quizplus · Accepted Answer

After a year, Julio will have to pay $262.50 (which includes the 5% interest). However, due to the 5% inflation, the real value of the $262.50 will be less than the real value of the $250 that Julio borrowed today. Therefore, Julio is better off as he gets to keep the real value of the $250 while only paying back $262.50. On the other hand, Ricky will receive $262.50 a year from now, which would give him a nominal return of 5%, but after adjusting for inflation, his real return will be 0% or even negative.

Julio Borrows $250 from Ricky