Answer to Question #211215 in Economics for ishant

Question

Suppose you are endowed with $200 today. You care both about how much

you can consume today and how much you can consume tomorrow. Sup-

pose you expect the inflation rate to be 5%. The following alternatives are

available to you:

A: Put some money in your cupboard.

B: Start a Fixed Deposit with some money in a bank providing an 8% interest

rate.

C: Borrow some money from a bank at a 10% rate of interest.

D: Invest some money in a financial instrument providing a 10% rate of

return.

Note that "some money" here means any amount out of the allocated

$200. Show using a diagram and simple algebra the best (largest) consump-

tion possibility. In words or using algebra explain why any other option is

not preferred.

Answer 1

If you expect the inflation rate to be 5%, then the most profitable alternative for you is to invest some money in a financial instrument providing a 10% rate of return, because in such case you can gain 10 - 5 = 5% of real return on your investment. Other alternatives are less profitable.

So, the best alternative is D.