Question
12. Inflation-induced tax distortions Ashwin receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest
12. Inflation-induced tax distortions
Ashwin 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 nominalinterest 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 Ashwin'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) |
2.5 | 4.5 | |||
7.0 | 4.5 |
Compared with higher inflation rates, a lowerinflation rate will the after-tax real interest rate when the government taxes nominalinterest 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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