Question

You place $4000 into an account paying 8% compounded annually. Inflation is expected to be 2.5% during each of the next three years. What is the account's value at the end of the 3 years in Year-O (constant) dollars?

a. $2029
b. $5040
c. $5428
d. $4680

Answer 1

FV= 4,680

Step-by-step explanation:

Because it is in constant dollars at year 0, we need to take into account the effect of the inflation rate on the investment. The inflation rate decreases the value of money through time. Therefore we need to subtract the inflation rate from the interest rate.

Real interest rate= 0.08 - 0.025= 0.055

Now, future value using the following formula:

FV= PV*(1+i)^n

FV= 4,000*1.055^3

FV= 4,000*1.17

FV= 4,680