Suppose that both the supply and demand for bonds depended only on the after-tax expected real...

Suppose that both the supply and demand for bonds depended only on the after-tax expected real interest rate, which is independent of the expected inflation rate. What is the effect of higher expected inflation on the bond market? (Hint: Because taxes are imposed on nominal interest income, bond demanders pay the tax, and bond suppliers have their taxes reduced by an equal amount because they can deduct the interest expense.) How does the amount of tax paid change when actual inflation is higher than expected inflation? Who gains and who loses from inflation?

Solutions

Expert Solution

Now, the supply and demand for bond depends on the “after tax expected real interest rate”. Now, as we know that the nominal interest rate is the sum of real interest rate and the expected inflation.

=> i = r + Ae, “i=nominal interest rate”, “r=real interest rate” and “Ae=expected inflation”. Now, if we add the tax rate “t” the the above equation can be written as.

=> (i-t) = (r-t) + Ae, where “r-t” be the after tax real interest rate.

Now, if “Ae” increases, => “i” will increases and “r” will remain same, => “r-t” remain same, => demand and supply of bond will remain same, => the bond market remain completely unaffected.

Now, once “i” is fixed and actual inflation higher than the expected inflation, => “A > Ae”, => “r” must decrease to maintain the above identity, => “r-t” decreases and “i-t” remain same, => the demand for bond decreases and supply is unaffected.

So, here amount of tax paid remain same, but here both the buyer and the sellers are worse off.

Rahul Sunny answered 2 years ago

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