The annual nominal rate of interest on a bank certificate of deposit is 12%. What would be the effect of an inflation rate of 13% and why?
Why are you taking such an out-of-date class? Most CDs are paying less than 1% per year.
idk. it's just a homework question to see if we understand the subject i guess.
To determine the effect of an inflation rate of 13% on a bank certificate of deposit with an annual nominal interest rate of 12%, you need to understand the concept of real interest rate. The real interest rate is essentially the nominal interest rate adjusted for inflation.
First, let's calculate the real interest rate using the following formula:
Real Interest Rate = Nominal Interest Rate - Inflation Rate
Real Interest Rate = 12% - 13% = -1%
The negative real interest rate (-1%) indicates that the purchasing power of the money invested in the certificate of deposit would actually decrease over time due to inflation. This means that even though you may earn an interest of 12% on the certificate of deposit, the inflation rate of 13% would erode the value of your money faster than what you are earning.
In simple terms, if the inflation rate exceeds the nominal interest rate, the real value of your investment will diminish. In this case, the effect of a 13% inflation rate would be to reduce the actual purchasing power of the money invested. Keep in mind that this analysis assumes a constant inflation rate throughout the investment period.