You make a loan to the government of $100. The government promises to pay you back some sum of money in two years. The interest rate will be 4 percent over that period, but inflation will be 4 percent. How much will you require that the government pay you in two years in the absence of any inflation? With inflation?
What will be an ideal response?
You could have saved the $100 dollars for two years, had X = 100(1.04) 2 = $108.16, but the
purchasing power of your money would have been decreased by inflation. So, to counter
those effects, you would ask for X = 100(1.08) 2 = $116.64.
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