Homework (Ch 17) 8. Inflation induced tax distortions Jake receives a portion of

Question

Homework (Ch 17) 8. Inflation induced tax distortions Jake receives a portion of his income from his holdings of interest-bearing us. 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 ake's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario Inflation Rate Real Interest Rate Nominal Interest Rate After-Tax Nominal Interest Rate After-Tax Real Interest Rate (Percent) (Percent) 2.0 7.0 (Percent) 2.5 2.5 (Percent) (Percent) Compared with lower inflation rates, a higher inflation rate wil nominal interest income. This tends to ? the after-tax real interest rate when the government taxes the quantity of investment in the economy and . saving, thereby the economy's long-run growth rate

Explanation / Answer

Government taxes nominal interest income at a rate of 10%.

Nominal interest rate = Real interest rate + Inflation rate

Real interest rate = Nominal interest rate - Inflation rate.

Compared with lower inflation rates, a higher inflation rate will decrease the after- tax real interest rate when the government taxes nominal interest rate income. This tends to discourage saving, thereby decreasing the quantity of investment in the economy and decreasing the economy's long run growth rate.

Inflation rate (percent) Real interest rate (percent) Nominal interest rate (percent) After-tax nominal interest rate (percent) After-tax real interest rate (percent) 2.0 2.5 (2.0 + 2.5)= 4.5 (4.5)- (0.1)(4.5) = 4.05 (4.05) - (2.0)= 2.05 7.0 2.5 (7.0+ 2.5)= 9.5 (9.5) - (0.1)(9.5)= 8.55 (8.55)- (7.0)= 1.55

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