Question

ney Growth and Inflation d Assignment Read Chapter 30 Back to Assignment Due Saturday 0427.19 at 11: Average: /2 tempts 8. Inflation-induced tax distortions Eric receives a portion of his income from his holdings of interest-bearing US government bonds. The bonds offer a real interest rate of 4.5% 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 4.5% per year, find the nominal interest rate on Erie's bonds, the after-tax nominal interest rate, and the after tax real interest rate under each inflation scenario. After-Tax Real Interest Rate Real Interest Rate (Percent) 4.5 4.5 After-Tax Nominal Interest Rate Inflation Rate (Percent) 2.0 9.5 Nominal Interest Rate (Percent) (Percent) (Percent) Compared with lower inflation rates, a higher infiation rate will nominal interest income. This tends to the after-tax real interest rate when the government taxes saving, thereby M the quantity of investment in the economy and the economy's long-run growth rate. Grade It Now Save & Continue Continue without saving

Answer 1

Nominal Interest Rate = Inflation rate + Real Interest Rate
= 2 + 4.5 = 6.5%
= 9.5 + 4.5 = 14%

After Tax Nominal Interest Rate = Nominal Interest Rate - Tax (10%)
= 6.5% - 0.65% = 5.85%
= 14% - 1.4% = 12.6%

After Tax real interest rate = After tax nominal interest rate - Inflation rate
= 5.85% - 2% = 3.85%
= 12.6% - 9.5% = 3.1%

A higher inflation rate will DECREASE the after tax real interest rate. This tends to DECREASE saving, thereby DECREASING the investment in the economy and DECREASE the economy's long run growth rate.