Question 6

6. The Fisher effect and the cost of unexpected inflation Suppose the nominal interest rate on car loans is 13% per year, and both actual and expected inflation are equal to 4%. Complete the first row of the table by filling in the expected real interest rate and the actual real interest rate before any change in the money supply. Nominal Interest Expected Rate Inflation Time Period (Percent) (Percent) Before increase in MS 13 4 Immediately after increase 13 4 in MS Actual Expected Real Interest Actual Real Interest Inflation Rate Rate (Percent) (Percent) (Percent) 4 [ ] L 6 ] ] Now suppose the Fed unexpectedly increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from 4% to 6% per year. Complete the second row of the table by filling in the expected and actual real interest rates on car loans immediately after the increase in the money supply (MS). The unanticipated change in inflation arbitrarily benefits v . Now consider the long-run impact of the change in money growth and inflation. According to the Fisher effect, as expectations adjust to the new, higher inflation rate, the nominal interest rate will w t0|:| per year. Grade It Now Save & Continue Continue without saving 8. 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 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. Grade It Now Save & Continue