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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.

Suggested Citation

  • David W.R. Gruen, 1991. "The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows," RBA Research Discussion Papers rdp9101, Reserve Bank of Australia.
    • Handle: RePEc:rba:rbardp:rdp9101
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    References listed on IDEAS

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    1. Willem H. Buiter & Marcus Miller, 1991. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 239-277, National Bureau of Economic Research, Inc.
    2. Alberto Alesina & David W. R. Gruen & Matthew T. Jones, 1991. "Fiscal Adjustment, The Real Exchange Rate and Australia's External Imbalance," Australian Economic Review, The University of Melbourne, Melbourne Institute of Applied Economic and Social Research, vol. 24(3), pages 38-51, July.
    3. Kathryn Dominguez & Jeffrey A. Frankel, 1991. "Does foreign exchange intervention matter? disentangling the portfolio and expectations effects for the mark," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
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    6. Martin Feldstein, 1983. "Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 28-43, National Bureau of Economic Research, Inc.
    7. 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.
    8. Ball, Laurence, 1992. "Why does high inflation raise inflation uncertainty?," Journal of Monetary Economics, Elsevier, vol. 29(3), pages 371-388, June.
    9. Tracey Horton & Jenny Wilkinson, 1989. "An Analysis of the Determinants of Imports," RBA Research Discussion Papers rdp8910, Reserve Bank of Australia.
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    11. Gordon, J M, 1986. "The J-Curve Effects," The Economic Record, The Economic Society of Australia, vol. 0(0), pages 82-88, Supplemen.
    12. Jeremy Smith & David W.R. Gruen, 1989. "A Random Walk Around the $A: Expectations, Risk, Interest Rates and Consequences for External Imbalance," RBA Research Discussion Papers rdp8906, Reserve Bank of Australia.
    13. Jeffrey A. Frankel, 1985. "The Dazzling Dollar," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 199-217.
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    Cited by:

    1. Tamim Bayoumi & Joseph E. 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. Kenneth F. Wallis, 1993. "On Macroeconomic Policy and Macroeconometric Models," The Economic Record, The Economic Society of Australia, vol. 69(2), pages 113-130, June.
    3. David W. R. Gruen & Jeremy Smith, 1994. "Excess Returns in a Small Open Economy," The Economic Record, The Economic Society of Australia, vol. 70(211), pages 381-396, December.
    4. D. Johannes Jüttner, 1993. "Interest Rates, Exchange Rates and Foreign Debt: Rejoinder," The Economic Record, The Economic Society of Australia, vol. 69(1), pages 80-81, March.
    5. K.F. Wallis, 1992. "On Macroeconomic Policy and Macroeconomic Modeling," Economics Discussion / Working Papers 92-04, The University of Western Australia, Department of Economics.
    6. 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.
    7. Cumberworth, Matthew & Milbourne, Ross, 1996. "External Debt and Liabilities: Evidence from a Cross Section of Countries," The Economic Record, The Economic Society of Australia, vol. 72(218), pages 201-213, September.
    8. Michele Bullock & Mark Rider, 1991. "The Cross-country Relationship between Interest Rates and Inflation over Three Decades," RBA Research Discussion Papers rdp9104, Reserve Bank of Australia.
    9. Nigel Dews & John Hawkins & Tracey Horton, 1992. "Measuring the Cost of Capital in Australia," RBA Research Discussion Papers rdp9205, Reserve Bank of Australia.
    10. Matthew Cumberworth & Ross Milbourne, 1996. "External Debt and Liabilities: Evidence from a Cross Section of Countries," The Economic Record, The Economic Society of Australia, vol. 72(218), pages 201-213, September.

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