Inflation-induced tax distortions

Tim 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 taxesnominalinterest 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 Tim's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario.

Inflation RateReal Interest RateNominal Interest RateAfter-Tax Nominal Interest RateAfter-Tax Real Interest Rate(Percent)(Percent)(Percent)(Percent)(Percent)2.04.58.54.5

Compared with lower inflation rates, ahigherinflation rate will the after-tax real interest rate when the government taxesnominalinterest income. This tends to saving, thereby the quantity of investment in the economy and the economy's long-run growth rate.