8. Inflation-induced tax distortions Rajiv 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 infiation 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 Rajiv'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 8.5 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.
8. Inflation-induced tax distortions Rajiv 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 infiation 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 Rajiv'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 8.5 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.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Transcribed Image Text:# Inflation-Induced Tax Distortions
Rajiv 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.
## Scenario Table
The table provides data for assessing nominal and real interest rates under different inflation conditions:
| 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 | 4.5 | | | |
| 8.5 | 4.5 | | | |
### Instructions:
Given the real interest rate of 4.5% per year, find the nominal interest rate on Rajiv's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario.
### Analysis:
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.
Fill in the blanks to understand the economic implications of tax and inflation on interest income.
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