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Suppose you are about to borrow $15,000 for four years to buy a new car. Briefly explain which of these situations you would prefer to be in: • The interest rate on your loan is 10%, and you expect the annual inflation over the next four years to average 8% • The interest rate on your loan is 6%, and you expect the annual inflation rate over the next four years to average 2%.

Suppose you are about to borrow $15,000 for four years to buy a new car. Briefly explain which of these situations you would prefer to be in: • The interest rate on your loan is 10%, and you expect the annual inflation over the next four years to average 8% • The interest rate on your loan is 6%, and you expect the annual inflation rate over the next four years to average 2%.

ENGR.ECONOMIC ANALYSIS
ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Please explain and provide the calculation for the real interest rate for both the situations

**Scenario Analysis for Car Loan** Suppose you are about to borrow $15,000 for four years to buy a new car. Briefly explain which of these situations you would prefer to be in: - **Scenario 1:** - The interest rate on your loan is 10%, and you expect the annual inflation over the next four years to average 8%. - **Scenario 2:** - The interest rate on your loan is 6%, and you expect the annual inflation rate over the next four years to average 2%. In evaluating these two scenarios, you would need to consider the real cost of the loan. Real cost is calculated as the nominal interest rate minus the inflation rate. This will help you understand which scenario gives you a better effective rate of interest when accounting for the inflation. 1. **Interest Rate vs. Inflation Analysis:** - **In Scenario 1**: - Interest Rate (Nominal): 10% - Expected Inflation Rate: 8% - Real Interest Rate = Nominal Interest Rate - Inflation Rate = 10% - 8% = 2% - **In Scenario 2**: - Interest Rate (Nominal): 6% - Expected Inflation Rate: 2% - Real Interest Rate = Nominal Interest Rate - Inflation Rate = 6% - 2% = 4% Thus, Scenario 1 has a lower real interest rate of 2% compared to Scenario 2's real interest rate of 4%. In conclusion, assuming all other conditions are equal, you would prefer Scenario 1 because the real cost of the loan is lower, meaning you would effectively pay less in real terms after accounting for the expected inflation. **Note:** This brief explanation highlights the importance of considering both nominal interest rates and inflation when evaluating loan terms. Understanding the real interest rate helps in making an informed financial decision.
Transcribed Image Text:**Scenario Analysis for Car Loan** Suppose you are about to borrow $15,000 for four years to buy a new car. Briefly explain which of these situations you would prefer to be in: - **Scenario 1:** - The interest rate on your loan is 10%, and you expect the annual inflation over the next four years to average 8%. - **Scenario 2:** - The interest rate on your loan is 6%, and you expect the annual inflation rate over the next four years to average 2%. In evaluating these two scenarios, you would need to consider the real cost of the loan. Real cost is calculated as the nominal interest rate minus the inflation rate. This will help you understand which scenario gives you a better effective rate of interest when accounting for the inflation. 1. **Interest Rate vs. Inflation Analysis:** - **In Scenario 1**: - Interest Rate (Nominal): 10% - Expected Inflation Rate: 8% - Real Interest Rate = Nominal Interest Rate - Inflation Rate = 10% - 8% = 2% - **In Scenario 2**: - Interest Rate (Nominal): 6% - Expected Inflation Rate: 2% - Real Interest Rate = Nominal Interest Rate - Inflation Rate = 6% - 2% = 4% Thus, Scenario 1 has a lower real interest rate of 2% compared to Scenario 2's real interest rate of 4%. In conclusion, assuming all other conditions are equal, you would prefer Scenario 1 because the real cost of the loan is lower, meaning you would effectively pay less in real terms after accounting for the expected inflation. **Note:** This brief explanation highlights the importance of considering both nominal interest rates and inflation when evaluating loan terms. Understanding the real interest rate helps in making an informed financial decision.
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