Question

Felix 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.
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 2.5
7.5 2.5
Compared with higher inflation rates a lower inflation will (increase/decrease) the after-tax real interest rate when the government taxes nominal interest income. This tends to (encourage/discourage) saving, thereby (increasing/decreasing) the quantity of investment in the economy and (increasing/decreasing) the economy's long-run growth rate.

Answer 1

4.5% 4.05% 2.25%

10% 9% 2.25

increase

encourage

increasing

increasing

Step-by-step explanation:

Nominal interest rate = real interest rate + inflation rate

2.0 + 2.5 = 4.5%

7.5 + 2.5 = 10%

Nominal after tax interest rate = nominal interest rate x (1 - tax rate)

4.5% x (1 - 0.1) = 4.05

10 x (1 - 0.1) = 9

Real after tax interest rate = real interest rate x (1 - tax rate)

2.5 x (1 - 0.1) = 2.25