Suppose that a change in the expected inflation rate leads supply and demand to adjust so that the after-tax expected real interest rate is unchanged at 2.0 percent.The tax rate is 30 percent.Initially, the expected inflation rate is 3.0 percent.If the expected inflation rate rises from 3 percent to 6 percent, the expected real interest rate
A)rises by 0.75 percent.
B)rises by 1.25 percent.
C)falls by 1.25 percent.
D)falls by 0.75 percent.

Question

Quizplus · Accepted Answer

Initially, the nominal interest rate was 5.5% (3% expected inflation + 2% expected real interest rate). After the change in expected inflation, the new nominal interest rate will be 8.5% (6% expected inflation + 2% expected real interest rate). However, since the tax rate is 30%, the after-tax nominal interest rate changes from 3.85% to 5.95%. 
To maintain the after-tax expected real interest rate unchanged at 2%, the expected real interest rate must increase by 1.25% (5.95% - 2% - (70% x 6%) = 3.95% - 1.25%). Therefore, the expected real interest rate rises by 1.25%.

Suppose That a Change in the Expected Inflation Rate Leads