Question

Assuming the following information:

a-Short-term nominal interest rate is 5%
b-Expected inflation of 2%.
c-Next year's nominal rate is expected to increase by 100 basis
d.points, but inflation will fall to

Answer 1

The problem of nominal interest rates transforming into real interest rates can be worsened by taxes. A person is taxed on nominal interest received, regardless of inflation. This can lead to people owing taxes on gains that are actually decreasing in buying power.

Step-by-step explanation:

The problem of a good-looking nominal interest rate transforming into an ugly-looking real interest rate can be worsened by taxes. The U.S. income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. Thus, the government taxes a person who invests $10,000 and receives a 5% nominal rate of interest on the $500 received-no matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all $500 is a gain in buying power. However, if inflation is 5%, then the real interest rate is zero and the person had no real gain-but owes income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5% and the person is actually falling behind in buying power, but would still owe taxes on the $500 in nominal gains.