# Loretta buys a one-year debt security on December 31, 2013, for \$10,000, which will pay her a nominal interest rate of 5% percent. From December 31, 2013, to December 31, 2014, the inflation rate is 2 percent. Loretta has a tax rate of 40 percent.

a.How much nominal interest (in dollars) does Loretta earn during the year? Show your calculations.  b.How much (in dollars) does Loretta pay in taxes on her interest income? Show your calculations.  c.How much (in dollars) is Loretta’s after-tax nominal income? Show your calculations.  d.How much principal (in dollars) does Loretta lose because of inflation? Show your calculations.  e.How much real interest income (in dollars) does Loretta earn? Show your calculations.  f.How much (in dollars) is Loretta’s after-tax real interest income? Show your calculations.  g.What percent of Loretta’s nominal interest income goes to: (1) her, in the form of after tax real interest income; (2) the government, in the form of taxes; and (3) inflation, in the form of lost principal value? Show your calculations.

What will be an ideal response?

a.Interest= principal × interest rate  = \$10,000 × 0.05 = \$500   b.Taxes= interest × tax rate  = \$500 × 0.40 = \$200   c.After-tax nominal income= interest − taxes  = \$500 − \$200 = \$300   d.Loss of principal to inflation= principal × inflation rate  = \$10,000 × 0.02 = \$200   e.Real interest income= nominal interest − loss of principal to inflation  = \$500 − \$200 = \$300   f.After-tax real income= real interest income − taxes  = \$300 − \$200 = \$100  or After-tax real income= after-tax nominal income − loss of principal to inflation  = \$300 − \$200 = \$100  g.Of the \$500 in nominal interest income, (1) Loretta gets \$100/\$500 = 20 percent; (2) the government gets taxes of \$200/\$500 = 40 percent; and (3) inflation gets \$200/\$500 = 40 percent.