Question

8. Inflation-induced tax distortions Sam receives a portion of his income from his holdings of Interest-bearing U.S. government bonds. The bonds offer a real Interest rate of 2.5% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate. The government taxes nominal Interest income at a rate of 10%. The following table shows two scenarios: a low-inflation scenario and a high- inflation scenario. Given the real interest rate of 2.5% per year, find the nominal interest rate on Sam's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario. Inflation Rate (Percent) 2.0 Real Interest Rate (Percent) Nominal Interest Rate (Percent) After-Tax Nominal Interest Rate (Percent) After-Tax Real Interest Rate (Percent) 2.5 7.5 Compared with higher inflation rates, a lower Inflation rate will nominal interest income. This tends to saving, thereby the economy's long-run growth rate. the after tax real interest rate when the government taxes the quantity of investment in the economy and

Answer 1

Answer:

Real interest rate = Nominal interest rate - inflation rate

so, nominal interest rate = real interest rate + inflation rate

After tax nominal interest = nominal interest rate*(1-tax rate) = Nominal interest rate x (1 - 0.1)

= Nominal interest rate x 0.9

After tax real interest rate = After tax nominal interest-inflation

Inflation Rate	Real Interest Rate	Nominal Interest Rate	After-Tax Nominal Interest Rate	After-Tax Real Interest Rate
(Percent)	(Percent)	(Percent)	(Percent)	(Percent)
2.0	2.5	2+2.5=4.5	4.5*(1-10%) = 4.05	4.05-2=2.05
7.5	2.5	7.5+2.5=10	10*(1-10%) = 9	9 – 7.5 = 1.5

(B)

A lower inflation rate will Increase after-tax real interest rate.

This tends to encourage savings, thereby increasing the quantity of investment and increasing long run growth rate.