Question

Four fundamental factors affect the cost of money: (1) the return that borrowers expect to earn on their investments, (2) the preference of savers to spend their income in the current period rather than delay their consumption until some future period, (3) the risks associated with the investment, and (4) expected inflation. Consider the following statements that address these factors, and indicate which you think are true.
Statement 1: The onset of 5% inflation means that your receipt of a $100 interest payment allows you to purchase only $95 worth of goods and services.
Statement 2: For the average rational investor or saver, there is an indirect, or inverse, relationship between the amount of risk exhibited by a security and the risk premium that would be required by the investor or saver.
Statement 3: On average and everything else held constant, rational savers and investors prefer to invest $1,500 to acquire an asset that will pay annual cash flows of $300 per year rather than an otherwise identical asset that will pay $500 per year.
Statement 4: The actual relationship between the risk-free rate of return (r*) and the expected future inflation rate or inflation premium (IP) is actually multiplicative-that is, [(1 + rRF) x (1 + IP)]-1-but it is often simplified to reflect an additive relationship.

The true statements are:

a. 2 and 3
b. 2 and 4
c. 1 and 4
d. 1 and 3

Answer 1

Answer:

The true statements are:

c. 1 and 4

Explanation:

The actual interest rate paid to savers depends on

(1) the expected rate of return on invested capital

(2) time preferences for current consumption versus future consumption

(3) the riskiness of the loan

(4) the expected future inflation rate

We can conclude that if an investment is facing a higher risk and inflation rate, then the expected interest rate will be higher than for a low-risk, low inflation-facing investment.