RDP 9101: The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows 4. Discussion

In a simple model of a closed economy, the domestic interest rate adjusts to equilibrate aggregate levels of saving and investment. Private saving and investment decisions depend on the after-tax real interest rate, which, when domestic inflation is expected to be steady at rate π, takes the form r_AT = i(1−τ) − π Other things equal, a change in the expected rate of domestic inflation induces a change in the domestic nominal interest rate which leaves the after-tax real interest rate unchanged – to ensure that aggregate saving and investment continue to balance. Thus, a change in steady inflation, dπ, induces a change in the nominal interest rate of and a change in the (pre-tax) real interest rate of . This more than one-for-one change in the nominal interest rate is often called the tax-adjusted Fisher effect.^[20]

This paper extends this simple closed-economy model to examine the interaction between inflation and the tax system in a world with free global capital flows. As we have seen in Section 2, if there is a constant inflation differential between the domestic economy and the world which is expected to be permanent, the tax-adjusted Fisher effect cannot apply to the domestic economy. Instead, international investors ensure that the domestic pre-tax real interest rate is equal to the world pre-tax real rate. This is the standard result.

However, introducing the possibility that the combination of steady domestic inflation, a non-inflation-neutral tax system and free global capital flows may end changes the nature of the equilibrium. In the models of Section 3, while “the combination” persists, the domestic pretax real interest rate is higher than the world pre-tax real rate and the real exchange rate is over-valued. This equilibrium is consistent with an efficient risk-neutral forward-looking foreign exchange market because of the ever-present possibility that a regime change will occur – leading to a capital loss on domestic nominal assets.

One might reasonably be sceptical about the details of each of the Section 3 versions of the model. Nevertheless, they suggest an important point. In a world with free global capital flows, relatively high domestic inflation and a tax system which is not inflation-neutral, the monetary authorities will find it necessary to hold the domestic short-term pre-tax real interest rate above the comparable world rate simply to keep inflation steady. Foreigners will find domestic short-term nominal assets attractive, and their demand for these assets will appreciate the domestic nominal and real exchange rate. When this happens, foreign investors will be aware of two things: that domestic interest rates are relatively high, and that the domestic exchange rate is over-valued. Equilibrium is established when the marginal foreign investor's assessment is that the excess return on the high domestic real interest rates is offset by the expected loss should the domestic currency depreciate in real terms.

In the real world, there are rather more sources of uncertainty than in the models of Section 3. Thus, for example, the authorities presumably view an over-valued real exchange rate as a cause for concern. If so, there are a range of available options – from “talking the currency down”, to intervention in the foreign exchange market (which seems to make a difference, see Dominguez and Frankel (1990)), to the possibilities examined in Section 3. It is probably fanciful to imagine foreign investors formally calculating their mathematical expectation for the change in the real exchange rate. Nevertheless, they presumably take informal account of the possibilities before deciding that there is profit to be made from the high domestic interest rates.

Note that it is not simply uncertainty which changes the nature of the equilibrium. Rather, it is asymmetrical expectations. Loosely speaking, for there to be an equilibrium with a real interest differential between the domestic economy and the world, foreign investors must assess the chance of the domestic real exchange rate depreciating as higher than the chance of it appreciating. The key argument in this paper is that, in the process of buying domestic nominal assets and appreciating the domestic real exchange rate, a point will be reached where foreign investors do have such asymmetrical expectations. That point represents an equilibrium in which the domestic economy sits until something changes.^[21]

In the models of Section 2 and Section 3, while “the combination” – of steady inflation, a non-neutral tax system and free global capital flows – persists, the domestic after-tax real interest rate, r_AT, is less than it would be with no domestic inflation. Provided private investment minus private saving rises as the after-tax real interest rate falls (which is usually assumed), the models imply that the interaction between inflation, a non-neutral tax system and free global capital flows leads to a larger domestic current account deficit.

Again, in all versions of the model, while “the combination” persists, the domestic real exchange rate is over-valued. It is not straightforward to establish that the Australian real exchange rate is over-valued. Thus, for example, while Figure 3 suggests that the terms of trade are an important determinant of the real exchange rate, it does not provide strong evidence that the real exchange rate is over-valued. However, the ratios of Australian import and export prices to the GDP deflator have both fallen significantly over the last six years (Alesina, Gruen and Jones (1990)), suggesting that relative prices are encouraging resources to leave the tradeable sector of the Australian economy. The analysis in this paper suggests that these relative price signals are a very undesirable consequence of the interaction between inflation, a non-neutral tax system and free global capital flows.

Footnotes

See Feldstein (1976) and Feldstein, Green and Sheshinski (1978) for more sophisticated models of the interaction between inflation and the tax system in a closed economy. [20]

For Australia, there is a further reason why investors may expect real depreciation. Over the last five years, Australia's current account deficit has averaged over five percent of GDP, a ratio much higher than the average of the previous two decades. Smith and Gruen (1989) suggest that foreign investors may expect significant real depreciation as part of the adjustment to external balance. [21]