Suppose Geoff Considers Borrowing $100 from Tracey

Essay

Suppose Geoff considers borrowing $100 from Tracey. They both think that a 4 percent real interest rate would be fair, but they are aware of a 30 percent interest income tax. Therefore, they think of the fair 4 percent real interest rate as an after-tax rate. How much should Geoff pay to Tracey in interest, such that the after-tax real interest rate would be 4 percent, if they expect inflation to be 6 percent? What if the expected inflation was 8 percent? How does this affect Geoff's incentive to borrow?