Dean borrows $400 from Tim. Tim wants to make a 10% real return on his money, so they both agree on a 10% interest rate paid next year. Dean and Tim did not anticipate any inflation, yet the actual inflation turned out to be 4% next year. In this case,
A) Tim is better off.
B) Dean will pay $56 a year from now on.
C) Dean is better off.
D) Tim will receive more than 10% of real rate of return a year from now.

Question

Quizplus · Accepted Answer

With a 10% interest rate, Dean will owe Tim $440 next year ($400 + 10% interest). However, with the 4% inflation rate, the purchasing power of $440 next year will be equivalent to only $422.40 today ($440/1.04). This means that Tim's real return is actually only 5.6% ($22.40/$400). Therefore, Dean is better off in this scenario because he is paying less in real dollars than what Tim is earning in real dollars. Option A is incorrect because Tim is not better off with only a 5.6% real return. Option B is incorrect because while Dean will owe $56 in interest next year, he will also owe the principal amount of $400, making his total payment to Tim $456. Option D is incorrect because Tim's real return is only 5.6%, not more than 10%.

Dean Borrows $400 from Tim