   Chapter 12, Problem 6PA

Chapter
Section
Textbook Problem

If the tax rate is 40 percent, compute the before-tax real interest rate and the after-tax real interest rate in each of the following cases.a. The nominal interest rate is 10 percent, and the inflation rate is 5 percent.b. The nominal interest rate is 6 percent, and the inflation rate is 2 percent.c. The nominal interest rate is 4 percent, and the inflation rate is 1 percent.

Subpart (a):

To determine

Real interest rate before and after the tax.

Explanation

Before the tax real interest rate is calculated using the formula:

Real interest rateBefore tax=Nominal interest rateBefore taxinflation rate (1)

Substitute the respective values in equation (1) to calculate the real interest rate.

Real interest rateBefore tax=105=5

Thus, before the tax real interest rate is 5%.

The reduction in the nominal interest rate (Reduction NI) due to 40% tax is given as follows:

Reduction in NI = 40100× Nominal interest rate= 0.4×10= 4

Thus, reduction in nominal interest rate due to tax is 4%

Subpart (b):

To determine

Real interest rate before and after the tax.

Subpart (c):

To determine

Real interest rate before and after the tax.

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