Question

Lorenzo receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 3% 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 3% per year, find the nominal interest rate on Lorenzo'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) 2.5 3.0 6.5 3.0 Compared with higher inflation rates, a lower 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.

Answer #1

Inflation rate(%) |
Real interest rate(%) |
Nominal real Interest(%) |
After-tax nominal interest rate(%) |
After-tax real interest rate(%) |

2.5 | 3.0 | 5.5 | 4.95 | 2.45 |

6.5 | 3.0 | 9.5 | 8.55 | 2.05 |

Compared with higher inflation rates, a lower inflation rate
will **decreases** the after-tax real interest rate
when the government taxes nominal interest income. This tends to
**decrease** saving, thereby **decrease**
the quantity of investment in the economy and
**lower** the economy's long-run growth rate.

**Nominal interest rate = real interest rate + inflation
rate**

**After tax Nominal interest rate = Nominal interest
rate(1-tax rate)**

**After tax real interest rate = real interest rate *
(1-tax rate) - inflation rate * tax rate**

Inflation-induced tax distortions
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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.
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The data in this table are for Wisconsin in August 2020. Use the
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Labor force participation rate
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Which bond should have the highest interest rate?
A.
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