During the 1980s interest rates in Australia were about 17%. What was the RBA's reason for this?

Question

i would also like to know international influences for this. Eg imports

Answer 1

10 October 1991

Three Decades of Real Interest Rates

full borrowing costs against current income

for tax purposes, even though the inflation

component was implicitly a repayment of

capital.

In these ways, entrenched high inflationary

expectations contributed to the asset price

boom in the second half of the 1980s. They

also help to explain the conundrum that very

strong demand for credit could persist

notwithstanding some very high real interest

rates.

After a time, of course, that demand

could not be sustained, and high real interest

rates eventually won out. But we were all

surprised by how far real interest rates had to

be pushed up, and how long they had to be

kept there, to check the asset price boom and

associated heavy demand for borrowed funds.

The Inflation/Tax Distortion

The mechanics of a conventional tax system,

as exists in all major countries, also contribute

to high real interest rates in an inflation

environment. This is because both the nominal

and real component of interest are deductible

for tax purposes.

Consequently, the higher the

inflation component of nominal interest rates,

the higher the nominal rates have to be raised

to achieve any given after-tax real interest

rates. To the extent that it is the latter that

matters for many borrowing decisions, the

achievement of a given contractionary policy

stance will require a higher before-tax real

interest rate, the higher is the rate of inflation.3

In Australia in the late 1980s, there was little

choice but to persevere with high real interest

rates if inflation was to be tackled seriously.

No one needs to be reminded that the effects

of those high real interest rates have been

far-reaching. Their effects, moreover, are not

confined to domestic borrowing decisions. If

high inflation countries have higher real

interest rates as a consequence, then real

exchange rates might also be pushed up as

foreign investors are attracted by the high real

interest rates.

High inflation economies might

actually go through periods of upward

pressure on their exchange rates. We have seen

this in a number of countries, including

Australia in recent times. The United

Kingdom, Canada and New Zealand in the

late eighties provide further examples, while

some new European Exchange Rate

Mechanism entrants, such as Spain, have

exhibited the same characteristic.

International Experience

I observed earlier that most countries

experienced generally low or negative real

rates in the 1970s and generally high, positive

rates in the 1980s.

It seems clear that when the largely

unanticipated lift in inflation occurred in the

1970s, the countries that experienced the

highest rates of inflation tended to have the

most negative real interest rates

If we start from a position where inflationary expectations are, say, 3 per cent and nominal interest rates are

5 per cent, and the corporate tax rate is 39 per cent, the after-tax real interest rate is .05 per cent. If inflationary

expectations were to rise to 10 per cent, nominal interest rates would have to rise to 161/2 per cent in order to

restore the real after-tax interest rate to .05 per cent. In the process, the pre-tax real interest rate (the one we

measure) would rise from 2 per cent to 61/2 per cent.