Let: (1) Pt be the price of one unit of a market basket of goods (i.e., a composite commodity) in year t; (2) P e be the expected price of one unit of a market basket of goods in year t + 1; (3) u e be the
Expected rate of inflation between period t and t + 1; and (4) it be the one- year nominal interest rate. Suppose an individual borrows the equivalent of one unit of a composite commodity today. Given this information, which of the following expressions represents (i.e., is equal to) the amount of the composite commodity one must repay in one year?
A) [(1 + u e )/(1 + it)]- 1.
B) [(1 + it) P e /Pt]- 1.
C) [(1 + u e )/(1 + it)]+1.
D) (1 + u e )/(1 + it).
E) (1 + it)Pt/ P e .

Question

Quizplus · Accepted Answer

The amount to be repaid in terms of the composite commodity is the nominal amount borrowed (1 unit) multiplied by the nominal interest rate (1 + it), adjusted for the expected price level in year t+1 (P e) relative to the price level in year t (Pt). Thus, the expression is (1 + it)Pt/ P e.

Let: (1) Pt Be the Price of One Unit of a Market