Given a nominal interest rate of 6 percent, in which of the following cases would you...

Given a nominal interest rate of 6 percent, in which of the following cases would you earn the lowest after tax real rate of interest? a) inflation is 4 percent, the tax rate is 5 percent.

b) inflation is 3 percent , the tax rate is 20 percent. c) inflation is 2 percent, the tax rate is 30 percent. d) The after tax real interest rate is the same for all of the above.

Solutions

Expert Solution

ANSWER:

Nominal interest rate = 6%

a) inflation is 4 percent, the tax rate is 5 percent.

Reduced nominal interest rate = nominal interest rate * tax rate = 6% * 5% = 0.3%

After tax nominal rate = nominal interest rate - Reduced nominal interest rate = 6% - 0.3% = 5.7%

the after tax real interest rate = After tax nominal rate - inflation rate = 5.7% - 4% = 1.7%

b) inflation is 3 percent , the tax rate is 20 percent.

Reduced nominal interest rate = nominal interest rate * tax rate = 6% * 20% = 1.2%

After tax nominal rate = nominal interest rate - Reduced nominal interest rate = 6% - 1.2% = 4.8%

the after tax real interest rate = After tax nominal rate - inflation rate = 4.8% - 3% = 1.8%

c) inflation is 2 percent, the tax rate is 30 percent.

Reduced nominal interest rate = nominal interest rate * tax rate = 6% * 30% = 1.8%

After tax nominal rate = nominal interest rate - Reduced nominal interest rate = 6% - 1.8% = 4.2%

the after tax real interest rate = After tax nominal rate - inflation rate = 4.2% - 2% = 2.2%

So, the lowest that i would earn is option c that is when inflation is 2 percent, the tax rate is 30 percent. as it has the highest real interest rate.

Rahul Sunny answered 1 year ago

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