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MAINTAINING THE PURCHASING POWER OF LOANED (OR INVESTED) MONEY

The Initial Deal

If John loans Bob $100 for 1 year at a 5% rate of interest, this is the economic equivalent of Bob selling John the
following bond:
1) a $100 principle, or $100 face value, or $100 par value;
2) a coupon interest rate of 5% per year that cannot be changed or altered; and,
3) a term to maturity, or expiration date, of one year.
The 3 details above are printed on the bond and can never be changed or altered.

𝐴 5% 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝑃𝑟𝑒𝑣𝑎𝑖𝑙𝑠 𝐼𝑛𝑖𝑡𝑖𝑎𝑙𝑙𝑦

Suppose the rate of inflation was 5% on the day John loaned $100 to Bob. Under these circumstances the purchasing
power of the bond’s future cashflows (John’s loan) is $100, as shown below.
𝐽𝑜ℎ𝑛′ 𝑠 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 $100+$5 (𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑙𝑒,$100)+ (𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡,$5)
( ) = 1.05 = (1)
𝑝𝑜𝑤𝑒𝑟, $100 {1+ (𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒, 5%)}

John wanted to buy a suit of clothes priced at $100 on the day he loaned $100 to Bob. Even though John could afford
the $100 suit, he decided to postpone the purchase one year. The 5% inflation rate will cause the price of that suit to
appreciate from $100 to $105 on the day Bob repays the loan from John. When Bob pays the [($100 principle) + ($5
interest) equals] $105 to John, John will still have enough money from the loan repayment to buy the suit at its higher
appreciated price of $105.

𝐼𝑓 𝑎 6% 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝐸𝑚𝑒𝑟𝑔𝑒𝑠 𝐿𝑎𝑡𝑒𝑟

Instead of 5%, suppose the inflation rate is 6% on the day the loan was originated. At this higher rate of inflation the
purchasing power of the bond’s future cashflows would be only $99.05 instead of $100. The higher rate of inflation
eroded the purchasing power of John’s money by ($100 - $99.05 =) 95 cents, as computed in equation (2).
𝐽𝑜ℎ𝑛′ 𝑠 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 $100+$5 (𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑙𝑒,$100)+ (𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡,$5)
( )= = (2)
𝑝𝑜𝑤𝑒𝑟, $99.05 1.06 {1+ (𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒, 6%)}

An inflation rate of 6% will cause the price of the suit John wants to appreciate from $100 to $106 on the day Bob repays
his loan from John. But, on the day Bob pays [($100 principle) + ($5 interest) equals] $105, John will not receive enough
money to buy the suit at its higher appreciated price of $106 because $106 > $105.

A Subtle but Important Lesson about Being a Successful Money Lender or Investor

Bankers, investors and other money lenders must always adjust the interest rate they charge on their loans to include an
Inflation Allowance. For example, if John had raised the interest rate he charged Bob by 1% because he expected the
inflation rate to accelerate from 5% to 6%, he would have charged Bob a higher interest rate of [(Initial interest rate, 5%)
+ (Inflation Allowance, 1%) equals] 6%. In other words: (𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 6%) =
(𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 5%) + (Inflation Allowance, 1%), as shown in the numerator of equation (3).

𝐽𝑜ℎ𝑛′ 𝑠 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 $100+$6 (𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑙𝑒, $100)+ (𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡,$5)+(Inflation Allowance, $1)


( ) = 1.06 = (3)
𝑝𝑜𝑤𝑒𝑟, $100 {1+ (𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒, 6%)}

Equation (3) shows that if John had raised the coupon interest rate he charged Bob from 5% to 6% he would have
maintained the purchasing power of his money and been able to afford to buy the new suit he wanted. Professional
bankers, investors and other money lenders realize this and they continually adjust their flexible market interest rates
accordingly.

Maintaining The Purchasing Power Of Loaned Money – Teaching Note – Professor Jack Clark Francis

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