Answered: 8. Inflation-induced tax distortions…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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8. Inflation-induced tax distortions

Musashi receives a portion of his income from his holdings of interest-bearing U.S. 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 Musashi'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)*	*(Percent)*	*(Percent)*	*(Percent)*
2.0	4.5
9.5	4.5

Compared with lower inflation rates, a higher inflation rate will __increase/decrease__the after-tax real interest rate when the government taxes nominal interest income. This tends to _encourage/discourage_ saving, thereby _Increasing/decreasing_the quantity of investment in the economy and _Increasing/decreasing__the economy's long-run growth rate.

8. Inflation-induced tax distortions
Musashi receives a portion of his income from his holdings of interest-bearing U.S. 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 Musashi'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)
(Percent)
(Percent)
(Percent)
2.0
4.5
9.5
4.5
Compared with lower inflation rates, a higher inflation rate will
the after-tax real interest rate when the government taxes
nominal interest income. This tends to
saving, thereby
the quantity of investment in the economy and
the economy's long-run growth rate.

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