Felix receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 4.5% 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.
Inflation Rate Real Interest Rate Nominal Interest Rate After-Tax Nominal Interest Rate After-Tax Real Interest Rate
(Percent) (Percent) (Percent) (Percent) (Percent)
2.0 2.5
7.5 2.5
Compared with higher inflation rates a lower inflation will (increase/decrease) the after-tax real interest rate when the government taxes nominal interest income. This tends to (encourage/discourage) saving, thereby (increasing/decreasing) the quantity of investment in the economy and (increasing/decreasing) the economy's long-run growth rate.