8. Inflation-induced tax distortions

Carlos receives a portion of his income from his holdings of interest-bearing 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 Carlos'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 higherinflation rate will increase or decrease? the after-tax real interest rate when the government taxes nominalinterest 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.