Your bank offers to pay you a 3% interest rate on a one-year fixed-deposit saving account. The inflation rate is expected to be 2% by the end of the year. Which of the following will be true if you decide to keep the money in the bank and the inflation rate turns out to be 4% by the end of the year? a. I will be worse off b. The bank will be worse off. c. Both the bank and I will be worse off. d. Neither the bank nor will be worse off.

a. I will be worse off

Explanation:

If inflation turns out to be 4%, this means that, for you to be in the same situation you were at the beggining of the year, in terms of purchased power you would have to earn 4% more. This means that, to be as good in terms of consumption as you were at the begging of the year, and be able to buy the same bundle of goods that you were able to buy at the beggining of the year, you should at least earn 4% more on your income. If you are being paid 3% on your savings, whith an inflation of 4%, you are loosing purchasing power (prices are increasing at a 4% rate and your income is increasing at a lower rate), then you are worst at the end of the year that at the beggining of the year. On the other hand, the situation of the bank would depend on how much interest is earning on loans. If the bank earns a 8% interest rate on loans, for example, while it pays 3% on deposits, it will have real profits: on $100 that were deposited, it will earn $8 by borrowing it, and it will pay $3 to the owner of the money. Finally, it will end up with 5% more dollars than it had at the beggining of the year, while it needed 4% more because of inflation: in this situation, the bank benefits.