Question

Suppose, that you put $100 in the bank on January 1, 2017. This time around, however, the annual nominal interest rate is 6 percent and the inflation rate is 4 percent. Much to your chagrin, the federal government treats interest income like wages and salaries and you have to pay income tax. Suppose you are in the 25% income tax bracket. The real return on your investment, i.e. after you've paid your tax liability is . Now, suppose that the nominal interest rate instead is 12 percent and inflation is 10 percent. In this case, the real after-tax return on your $100 deposit is .Suppose, that you put $100 in the bank on January 1, 2017. This time around, however, the annual nominal interest rate is 6 percent and the inflation rate is 4 percent. Much to your chagrin, the federal government treats interest income like wages and salaries and you have to pay income tax. Suppose you are in the 25% income tax bracket. The real return on your investment, i.e. after you've paid your tax liability is . Now, suppose that the nominal interest rate instead is 12 percent and inflation is 10 percent. In this case, the real after-tax return on your $100 deposit is

Answer 1

1. In the scenario where Interest rate is 6% and inflation rate is 4%; annual real return on the investment will be $0.5 or 0.5%;

2. In the scenario where Interest rate is 12% and inflation rate is 10%; annual real return on the investment will be -1 or -1%

Step-by-step explanation:

1. In the scenario where Interest rate is 6% and inflation rate is 4%:

- Your before-tax interest income will be: 100 x 6% = $6

- Your after-tax interest income will be: 6 x (1-25%) = $4.5

- Your inflation cost will be: 100 x 4% = $4

- Your net annual real return will be: $4.5 - $4 = $0.5 or 0.5/100 = 0.5%

2. In the scenario where Interest rate is 12% and inflation rate is 10%; annual real return on the investment:

- Your before-tax interest income will be: 100 x 12% = $12

- Your after-tax interest income will be: 12 x (1-25%) = $9

- Your inflation cost will be: 100 x 10% = $10

- Your net annual real return will be: $9 - $10 = -$1 or -1/100 = -1%