Interest, Inflation, and Purchasing Power: A Sports Fan's Dilemma
How does inflation impact the purchasing power of a sports fan's savings deposit?
Suppose a sports fan, Devon, deposits $2,000 in a savings account with a fixed annual nominal interest rate of 5% and initially buys football tickets priced at $10 each. As inflation rates vary, how does it affect the price of football tickets, Devon's purchasing power, and the real interest rate?
Impact of Inflation on Purchasing Power
When inflation rates rise, the purchasing power of Devon's savings deposit declines due to the increased price of football tickets.
Understanding the Impact of Inflation on Purchasing Power
Devon, a devoted sports fan, decides to invest $2,000 in a savings account with an annual nominal interest rate of 5%. Initially, she spends her savings on football tickets priced at $10 each. However, as inflation rates fluctuate, the affordability of football tickets and the real value of Devon's deposit change.
When inflation remains at 0%, the price of a football ticket stays at $10, allowing Devon's deposit to cover 200 football tickets. The real interest rate is 5%.
With a 2% inflation rate, the new price of a football ticket increases to $10.20. This adjustment reduces Devon's purchasing power to approximately 196 tickets, resulting in a real interest rate of 3%.
As inflation escalates to 5%, the cost of a football ticket rises to $10.50. Consequently, Devon's deposit now enables her to purchase around 190 tickets, and the real interest rate dips to 0%.
It is evident that inflation erodes the purchasing power of Devon's savings deposit over time, impacting her ability to buy the same quantity of football tickets despite the nominal interest rate.