Luigi is willing to lend Klaus $5,000 for one year at a nominal rate of interest of 7%. Both Luigi and Klause expect the rate of inflation to be 2% in the next year. How much additional purchasing power will Luigi have in one year?

A. $5,250

B. $350

C. $250

D. $5350

Option (C) $250

Explanation:

Data provided in the question:

Amount willing to lend i. e Loan = $5,000

Nominal rate of interest = 7%

Rate of inflation = 2%

Now,

Purchasing power in one year = Loan * (1 + Real interest rate)

= Loan * [ 1 + (Nominal rate of interest - Rate of inflation) ]

= $5,000 * [ 1 + (7% - 2%) ]

= $5,000 * [ 1 + 5% ]

= $5,000 * [ 1 + 0.05 ]

= $5,250

Hence,

Additional purchasing power in one year = $5,250 - $5,000

= $250

Option (C) $250