Suppose that a typical taxpayer has a marginal personal income tax rate of 35 percent. The nominal interest rate is 13 percent, and the expected inflation rate is 8 percent.
a. What is the real after- tax rate of interest?
b. Suppose that the expected inflation rate increases by 3 percentage points to 11 percent, and the nominal interest rate increases by the same amount. What happens to the real after- tax rate of return?
c. If the inflation rate increases as in part b, by how much would the nominal interest rate have to increase to keep the real after- tax interest rate at the same level as in part a ? Can you generalize your answer using an algebraic formula?