Expected inflation also can distort financial decisions because lenders pay taxes on nominal rather than real returns. Suppose that expected inflation is 4% and that an individual faces a marginal tax rate of 30%. A nominal interest rate of 8% yields the individual a real after-tax return of (1-0.30)(8%)-4%=1.6%. Suppose that the expected inflation rate rises to 8%and that the nominal interest rate rises by the same amount to 12%. The real after -tax return falls to (1 -0.30) -8%=0.4%. Hence nominal interest rates would have to increase by more than the change in inflation (8%-4%)to maintain the real return of 1.6%. Conversely, borrowers such as corporations and individual home buyers benefit from expected inflation, because borrowers deduct nominal interest payments (not real interest payments)in calculating their income tax liabilities. Changes in expected inflation can change the real after-tax cost of borrowing. For example, with high expected inflation,corporations find debt financing more attractive,because nominal interest payments are deductible. Households find housing investment more attractive relative to stocks,because home mortgage interest is deductible for tax purposes.

A third cost of expected inflation in the new Keynesian approach arises from so-called "menu costs",or costs to firms of changing prices(reprinting p[rice lists,informing customers,and so on). Faced with different menu costs,not all firms change prices at the same time;that is,price changes brought on by inflation are not synchronized throughout the economy. Even so,expected inflation can change relative prices in the short run and affect the allocation of the economy,s resources.

## Thursday, April 23, 2009

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