Question

The following example illustrates how inflation raises the tax burden on saving:

Economy A                    Economy B

        Nominal Interest Rate             5%                             10 %

        Inflation Rate                     3%                             (b)

        Real interest rate                 (a)                              4 %

        Reduced interest due to 20% tax

            (0.2 x nominal interest rate)    1%                            2 %

        After-tax nominal interest rate

           (0.8 x nominal interest rate)     4 %                            8%

        After tax real interest rate          (c)                             (d)

        Fill in with appropriate numbers: (a)___________ (b)___________ (c)__________ (d)____________

Answer 1

	Economy A	Economy B
Nominal interest rate	5%	10%
Inflation rate	3%	b
Real interest rate	a	4%
Reduced interest due to 20% tax	1%	2%
After tax nominal interest rate	4%	8%
After tax real interest rate	c	d

Nominal interest rate = Real interest rate - Inflation rate

Real interest rate = Nominal interest eare + Inflation rate.

After tax real interest rate = After tax nominal interest rate - Inflation rate.

Economy A.

Real interest rate = 5% - 3%

Real interest rate = 2%

Hence, the value for point ' a ' is 2%

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After tax real interes rate = 4% - 3%

After tax real interest rate = 1%

hence, the value of point ' c ' is 1%

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Economy B.

Nominal interest rate = Real Interest rate + Inflation rate.

=> Inflation rate = Nominal interest rate - Real Interest rate.

=> Infltion rate = 10% - 4%

=> Inflation rate = 6%

Hence, the value of point ' b ' is 6%.

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After tax real interes rate = 8% - 6%

After tax real interest rate = 2%

hence, the value of point ' d ' is 2%