If inflation is lower than expected. The value of the real after tax interest expense increases. Why? Thanks
Makes sense. If inflation is lower than expected, then a currency’s purchasing power has eroded by less than anticipated. So whether we’re talking about the cash in your wallet or an after tax interest expense, it’s all more valuable than it would have been had actual inflation matched expected inflation.
Let me try. If you think inflation 1 year down the line would be say 10%. Because of this, you would loan the amount at say 15%. so that after adjusting inflation you will get 5% return (15%-10%=5% which is called real return). but after 1 year actual inflation is only 5% which means you, as a lender got, (15%-5% inflation=10% as against your expected real return of only 5%). Since you said interest expense, think this in terms of borrower. Actually he is paying 10% real interest against your required 5% real interest. Since he is paying more interest than what is in the present scenario (others at this time would have loaned at 10%), the value of interest expense from the borrower perspective is more. The login remains same even if you consider after tax, which is relative %. Borrower perspective scen1: 15% - tax @ say 20% = 15-3= 12 real interest after tax = 12% - inflation 10% = 2% actual inflation less than expected: 15% - tax @ say 20% = 15-3= 12 real interest after tax = 12% - inflation 5% = 7% Hope this explains.
It does. Thanks guys.