1.4. Let's see just how much high expected inflation can hurt incentives to save for the long run.

Let's assume the government takes about one third of every extra dollar of nominal interest you earn (a reasonable approximation for recent college graduates in the United States). You must pay taxes on nominal interest-just like under current U.S. law-but if you're rational, you'll care mostly about your real, after-tax interest rate when deciding how much to save.

To make the economic lesson clear, note that in every case, the real rate (before taxes) is an identical 3%. In each case, calculate the nominal after-tax rate of return and the real after-tax rate of return. Notice that as inflation rises, your after-tax rate of return plummets.

Nominal interest rate 15%

6%

12%

90%

900%

E7r = 7r Inflation

(no surprises)

12%

3%

9%

87%

897%

2 X.

J I

Nominal after-tax return 10%

( 1 X ;) - 7i'

Real after-tax return -2%