If your after-tax expected real interest rate is 3 percent and your expected inflation rate is 2 percent, what was the nominal interest rate on your one-year bond if you faced a tax rate of 20 percent?
A)5.0 percent
B)5.75 percent
C)6.0 percent
D)6.25 percent

Question

Quizplus · Accepted Answer

To find the nominal interest rate, we use the formula: 
nominal interest rate = real interest rate + inflation rate 
First, we need to adjust the real interest rate for taxes: 
after-tax real interest rate = (1 - tax rate) x real interest rate 
= (1 - 0.20) x 0.03 
= 0.024 or 2.4%

Next, we add this after-tax real interest rate to the expected inflation rate: 
nominal interest rate = after-tax real interest rate + inflation rate 
= 2.4% + 2% 
= 4.4%

Therefore, the nominal interest rate on the one-year bond is 4.4%.

If Your After-Tax Expected Real Interest Rate Is 3 Percent