Bill borrows $200,000 for three years from Larry and agrees to pay Larry 8 percent interest, compounded annually. The entire amount of the loan plus interest will be paid at the end of the third year. The price level at the time of the loan is 1.00.
(a) What is the amount that Larry will receive at the end of the third year? If the price level is 1.00 at the end of the third year, what is the real value of the payment received by Larry?
(b) Assume that the inflation rate in the economy is 3 percent per year for each of the three years. What is the price level at the end of the third year? What is the real value of the payment received by Larry?
(c) Again, assume that the inflation rate in the economy is 3 percent per year for each of the three years. In this case, however, Larry had indexed the loan to protect himself from inflation. What would be the nominal interest rate for each year of the loan? What is the nominal amount of the payment received by Larry at the end of the third year? What is the real value of the payment?