Q1: Inflation and Interest Rates
True because market participants in countries with high inflation rates tend, if the inflation is persistent, to expect high inflation. Since contracted real interest rates do not differ a lot between countries, countries with high expected rates of inflation will tend to have higher nominal interest rates than countries with low expected inflation. This argument uses the Fisher equation
i = r + Ep
where i is the nominal interest rate, r is the ex ante or contracted real rate of interest and Ep is the public's expected rate of inflation.
As CHART 1 below indicates, the dentist, speaking in 1959, was only a bit off in his guess as to what had happened to the price level since 1929. The price level in Canada actually increased about 1.75 rather than 2 times over the three decades.
The dentist's guess about interest rates was also quite accurate as indicated in CHART 2 below. The long-term government bond rate was 4.9 percent per year in 1929 and 5.0 percent per year in 1959. Despite substantial movements in the actual inflation rate, the interest rate on long-term government bonds remained quite stable.
Our theory together with the above evidence tells us that people's expectations of future inflation were not much different in 1959 than they were in 1929, even though the price level had almost doubled between the two years.
The dentist goes off-base when he makes the statement that the interest rate is the "price of money". Rather, it is the price of spending money today rather than spending it next year. A doubling of all prices (or, more correctly, of the average of all prices) in the economy does not necessarily mean that the penalty for spending one's income today rather than next year has increased---today's money and next year's money may both be worth only half as much as they previously were. As long as the expected inflation rate is the same in 1959 as it was in 1929 it is reasonable to expect that market interest rates would also be about the same since real interest rates typically do not change much over long periods in economies in which risk does not change dramatically.
Let's look again at the Fisher Equation
i = r + Ep
where i is the nominal interest rate, r is the real interest rate which borrowers and lenders expect to pay and receive, and Ep is the expected rate of inflation. Assume that these are per annum rates.
When people expect a higher future rate of inflation, they tack on a higher premium Ep to the real interest rate they are willing to pay and receive to compensate for the expected future decline in the real value of the loan.
Unexpected inflation will reduce the amount of real goods the borrower will have to give up to pay off the loan below what he/she had expected to give up. It will thus shift wealth from lenders to borrowers. An unexpected deflation, or lower level of inflation than expected, will shift wealth from borrowers to lenders because borrowers will have to give up more real goods than expected to pay back the loan.
Suppose that the underlying contracted real interest rate (the real interest rate that borrowers and lenders are willing to accept in making their contracts) was 3 percent per annum in 1929 and also 3 percent in 1959. Suppose further that the expected rate of inflation in 1929 was 2 percent per year. Then the observed market interest rate in 1929 would have been 5 percent per annum. For the nominal or observed market interest rate to double between 1929 and 1959, the expected rate of inflation in 1959 would have to have been 7 percent [7 + 3 = (2)(5) = 10].
It is apparent that the expected rate of inflation did not increase much between 1929 and 1959 because the market interest rate increased only slightly. This is the case despite the fact that the price level doubled over that period.
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