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The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows

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  • David W.R. Gruen

    (Reserve Bank of Australia)

Abstract

Over the last six years, Australia has experienced relatively high steady inflation and high real interest rates – especially short-term rates. This paper argues that these high real rates are a consequence of the interaction between the relatively high inflation and a tax system which taxes nominal income. The paper then explains how these high real rates can persist in a world with free global capital flows. We argue that foreign lenders find Australian nominal assets attractive, and their demand for them appreciates the Australian real exchange rate. However, foreign demand for Australian nominal assets is not insatiable. Having driven up the Australian real exchange rate, foreigners eventually conclude that the excess return on the high Australian interest rates is offset by the possibility that the overvaluation of the real exchange rate will unwind. The paper formalizes these ideas in a model.

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Bibliographic Info

Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9101.

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Date of creation: Feb 1991
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Handle: RePEc:rba:rbardp:rdp9101

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References

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  1. Buiter, Willem H. & Miller, Marcus, 1982. "Real exchange rate overshooting and the output cost of bringing down inflation," European Economic Review, Elsevier, vol. 18(2), pages 85-123.
  2. Feldstein, Martin S, 1976. "Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis," American Economic Review, American Economic Association, vol. 66(5), pages 809-20, December.
  3. Dominguez, Kathryn & Frankel, Jeffrey A., 1990. "Does Foreign Exchange Intervention Matter? Disentangling the Portfolio an Expectations Effects for the Mark," Department of Economics, Working Paper Series qt84c522k9, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  4. Jeffrey A. Frankel, 1987. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," NBER Working Papers 2367, National Bureau of Economic Research, Inc.
  5. Ball, Laurence, 1992. "Why does high inflation raise inflation uncertainty?," Journal of Monetary Economics, Elsevier, vol. 29(3), pages 371-388, June.
  6. Frankel, Jeffrey & Engel, Charles M., 1984. "Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test," Journal of International Economics, Elsevier, vol. 17(3-4), pages 309-323, November.
  7. Gordon, J M, 1986. "The J-Curve Effects," The Economic Record, The Economic Society of Australia, vol. 0(0), pages 82-88, Supplemen.
  8. Jeffrey A. Frankel, 1985. "The Dazzling Dollar," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 199-217.
  9. Buiter, Willem H & Miller, Marcus, 1981. "Monetary Policy and International Competitiveness: The Problems of Adjustment," Oxford Economic Papers, Oxford University Press, vol. 33(0), pages 143-75, Supplemen.
  10. Liviatan, Nissan, 1980. "Anti-Inflationary Monetary Policy and the Capital Import Tax," The Warwick Economics Research Paper Series (TWERPS) 171, University of Warwick, Department of Economics.
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Cited by:
  1. Tamim Bayoumi & Joseph Gagnon, 1992. "Taxation and inflation: a new explanation for current account imbalances," International Finance Discussion Papers 420, Board of Governors of the Federal Reserve System (U.S.).
  2. Bayoumi, Tamim & Gagnon, Joseph, 1996. "Taxation and inflation: A new explanation for capital flows," Journal of Monetary Economics, Elsevier, vol. 38(2), pages 303-330, October.

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