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A major source of funds for capital investment is long-term borrowing, through the issue of bonds that are usually repayable after ten or more years. However, severe inflation makes it much less attractive to corporations to engage in long-term borrowing, by forcing interest rates to high levels. Inflation causes high interest rates in two ways: first, lenders demand an interest “premium” to compensate them for the declining value of their capital, and, second, the policies used by the government to restrain inflation involve increases in interest rates. In particular, the very high interest rates associated with the severe inflation of the 1970′s made many corporations reluctant to raise capital through bond issues that would commit them to paying very high interest expenses for many years.

It seems logical that such high interest rates would at least provide people with strong incentives to save, but this is not so, due to the effects of inflation and taxation. Figure 15-4 shows the return on $100 of savings invested at a 15-percent rate of interest for one year during which the rate of inflation is 12 percent. Although 15 percent seems like a high rate of interest, this is very misleading. While $15 of interest income is received, the purchasing power of the lender’s capital declines by $12 (12 percent of $100) due to inflation, leaving a real return of $3. Assuming that income tax is payable at a rate of 40 percent on the interest income, taxes will amount to $6 (40 percent of $15), leaving a net after-tax return of -$3.

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