M & B 4th Edition by Dean Croushore

Exercise 13

Suppose that both the supply and demand for bonds depended only on the after-tax expected real interest rate, which is independent of the expected infl ation rate. What is the effect of higher expected infl ation on the bond market? ( Hint: Because taxes are imposed on nominal interest income, bond demanders pay the tax, and bond suppliers have their taxes reduced by an equal amount because they can deduct the interest expense.) How does the amount of tax paid change when actual infl ation is higher than expected infl ation? Who gains and who loses from infl ation?