Answered: Suppose that you are running a…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Suppose that you are running a business, and you need some extra space for one year. Your bank offers you a loan of $200,000 at 0% interest. You consider borrowing this amount to buy the building, use it for one year, and then sell the building to pay back the loan.

Unfortunately, the economy in which you are operating is experiencing deflation at the rate of 10% per year.

After one year, you should be able to sell the building for___________.

Suppose that owning the building for a year would earn you $12,000. To decide whether you will be better off by owning it for one year and then selling it, you seek advice from three different people: (1) Your brother says that you should not buy the building because in one year it will cost you $200,000. (2) Your accountant says that you should definitely buy the building because you can borrow $200,000 at zero interest while the building will generate $12,000 in extra income. Then when you sell it, you will be $12,000 richer. (3) Your bookkeeper says that if you sell the building in a year, you will have to come up with more money to pay off the loan than you will make in extra income.

Keeping in mind that the economy experiences deflation at the rate of 10%, your ____ (brother/bookkeeper/accountant) is right because (choose 1):

When the nominal interest rate is zero, you do not incur any cost when you take out a loan

The extra income you will earn will be less than the cost of owning the building for the year

When the nominal interest rate is zero, the cost of a building is its full purchase price

Now, suppose you inherit $200,000 in cash from your uncle who had kept it hidden in his mattress.

Assuming the nominal interest rate is –1%, which of the following options will maximize the amount of cash that you have in one year? (choose 1)

Buying the building, because you can earn an additional $12,000 in income if you own the building for one year and then sell it

Depositing the cash in a bank, because the 10% deflation makes the value of your dollars fall even more rapidly than 1% per year

Holding on to your $200,000 in cash

True or False: A high real interest rate will keep firms from borrowing to finance investment in capital, but it will not keep firms with cash from investing in capital.

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