The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows
AbstractOver 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 InfoPaper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9101.
Date of creation: Feb 1991
Date of revision:
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- 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.).
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