You lend $5,000 to a friend for one year at a nominal interest rate of 10%. Inflation during that year is 5%. As a result, you will receive at the end of the year, but that money has a purchasing power of .

$500, $250

Explanation:

You lend $5,000 to a friend for one year at a nominal interest rate of 10%. Inflation during that year is 5%. As a result, you will receive $500 at the end of the year, but that money has a purchasing power of $250.

The nominal rate determines the amount that will received which is 10% of $5000 = $500

However the real rate determines the purchasing power of the amount to be received which is: Nominal rate - Inflation rate = Real rate,

Therefore the real rate = 10% - 5% = 5%

5% x 1000 = $250

Inflation is the single major factor that affects the purchasing power of money, hence the inflation effect must always be subtracted from any returns lenders are expecting, to get their real returns.

As a result, you will receive $5,500 at the end of the year, but that money has a purchasing power of $5,238.

Explanation:

At the end of the year, you will receive $5,000 x (1 + 10%) = $5,000 x 1.1 = $5,500. That is basically the future value of your money.

But in order to determine the purchasing power of that money, we must determine its present value using the inflation rte as our discount rate:

present value = future value / (1 + r) = $5,500 / 1.05 = $5,238.10 ≈ $5,238

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