Inflation-induced tax distortions Chris 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 Chris'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) 3.0 4.5 9.5 4.5 Compared with lower inflation rates, a higher inflation rate will (INCREASE or DECREASE) the after-tax real interest rate when the government taxes nominal interest income. This tends to (ENCOURAGE or DISCOURAGE) saving, thereby (INCREASING or DECREASING) the quantity of investment in the economy and (INCREASING or DECREASING) the economy's long-run growth rate.
Inflation-induced tax distortions Chris 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 Chris'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) 3.0 4.5 9.5 4.5 Compared with lower inflation rates, a higher inflation rate will (INCREASE or DECREASE) the after-tax real interest rate when the government taxes nominal interest income. This tends to (ENCOURAGE or DISCOURAGE) saving, thereby (INCREASING or DECREASING) the quantity of investment in the economy and (INCREASING or DECREASING) the economy's long-run growth rate.
Chapter7: International Arbitrage And Interest Rate Parity
Section: Chapter Questions
Problem 18QA
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Question
Inflation-induced tax distortions
Chris 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 Chris'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)
|
| 3.0 | 4.5 |
|
|
|
| 9.5 | 4.5 |
|
|
|
Compared with lower inflation rates, a higher inflation rate will (INCREASE or DECREASE) the after-tax real interest rate when the government taxes nominal interest income. This tends to (ENCOURAGE or DISCOURAGE) saving, thereby (INCREASING or DECREASING) the quantity of investment in the economy and (INCREASING or DECREASING) the economy's long-run growth rate.
Expert Solution
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Step 1
Inflation
Each unit of currency may purchase fewer products and services as the general price level rises, hence inflation is associated with a decline in the purchasing power of money. Deflation, which is a drop in the general level of prices for goods and services, is the reverse of inflation.
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