Research Discussion Paper – RDP 9101 The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows


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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