02.

04 Interest Rates and Inflation

Part One—Select Two Savings Options

Select one savings option from the Simple Interest column and one from the Compound Interest
column to compare:

Simple Interest - Option A (earns 2.5% simple interest per year)

Compound Interest - Option E (earns 2.5% compound interest per year)

Part Two—Crunch the Numbers

Calculate the after-tax real rate of return earned on $5,000 by your selected savings options over a
period of three years. This will help your comparison. Remember, the real rate of return includes
taxes on the interest earned and inflation. For this assignment, use a tax rate of 10% and an average
cumulative rate of 3%.

Step 1: Calculate the interest earned

Year One - Multiply the amount deposited by the interest rate.

Simple Interest: $125

Compound Interest: $125

Year Two—For simple interest, multiply the amount

deposited by the interest rate.
For compound interest, multiply the sum of the amount deposited and the year one interest by the
interest rate.

Simple Interest: $125

Compound Interest: $128

Year Three—For simple interest, multiply the amount

deposited by the interest
rate. For compound interest, multiply the sum of the amount deposited, the year one interest, and
the year two interest by the interest rate.

Simple Interest: $125

Compound Interest: $131

Total Interest Earned (Simple Interest): $375

Total Interest Earned (Compound Interest): $384

Step 2: Calculate the taxes on the interest earned

Multiply the total interest earned by a tax rate of 10%.

Simple Interest: 37.5

Compound Interest: 38.4

Step 3: Calculate the inflation on the interest earned Multiply the total interest earned by a
cumulative inflation rate of 3%.

Simple Interest: 11.25 Compound Interest: 11.52

Step 4: Find the after-tax real rate of return Subtract the taxes and inflation from the interest
earned. Simple Interest: $326.25 Compound Interest: $334.08 Final Amount After Three Years:
Simple Interest: $5,326.25

Compound Interest: $5,334.08

Part Three—Make Your Recommendation

Compile your calculations and make a recommendation. Of the savings options that you chose,
which would you recommend a depositor use? Use complete sentences to explain why one option
would be more beneficial than the other based on the after-tax rate of return. Of the saving options
that I chose (earning 2.5% simple interest per year and earning 2.5% compound interest per year), I
would strongly recommend the earning of 2.5% compound interest per year. It allows more interest
to increase the amount of money in your account, which keeps increasing over the years. After the
after-tax rate of return after three years, the result of the earning of 2.5% simple interest per year
was $5,326.25, while the result of the earning of 2.5$% compound interest per year was $5,334.08.
Even though it is not a huge difference after three years, it will keep getting bigger over the years,
while the simple interest will stay the same.