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(a) Discuss the effects of higher expected inflation on bond markets.

(b) Explain what the authorities might hope to achieve by raising interest rates at an early stages of an upward cycle.

The fear of an upsurge in inflation is due, in this case, to political reasons. In 1996, one year before general elections, investors feared that the government might 'go for growth', by loosening fiscal policy, with the aim of gaining another term in office. For an economy already in good shape, this would arouse concerns about the level of inflation.

(a) Because of fears that the government goes for growth, financial markets anticipate higher inflation.  Since bonds have a fixed nominal interest, a rise in expected inflation decreases the real return on bonds.  Demand for bonds diminishes and financial operators substitute away from them. To restore the equilibrium on the market, since demand decreases, the value of government bonds must fall, thus implying a rise in their implicit real interest rate.

For example, if the value of the bond is £100, with a coupon of £10, the real interest rate is 10% if there is no inflation.  If expected inflation is 5%, the real interest rate falls to 5%.  Demand for bonds decreases, as their price, until equilibrium is restored when the new price is around £67.  At this point, the nominal interest rate is 10/67 = 15% and the real interest rate is 15% - 5% = 10%.  For the government, this automatic process of adapting to new inflationary expectations means that financing deficits through inflation is ineffective if inflation is correctly anticipated.

(b) If the economic authorities raise interest rates, economic activity is slowed down.  Inflationary pressure eases and a strong signal goes out to the market that inflation will not be tolerated.  Eventually, the higher cost of borrowing money has a negative impact on investment and consumption, restraining economic activity and inflation.  Since this process has a time horizon of 1-2 years, the early move by authorities is welcomed because the final point of this chain is more likely to be reached before the economy runs at full capacity, that is, before inflation might rise.

Q4 Addressing a symposium in 1994, D.T. Brash, Governor of the Central Bank of New Zealand, remarked that 'the best contribution monetary policy can make to growth and employment is to maintain stability in the general level of prices'. (Address to the Federal Reserve Bank of Kansas Symposium, Reducing Unemployment: Current Issues and Policy Options, Wyoming, 1994).

Does attaining price stability implicitly mean that interest rates must be variable?

This statement presumes a monetary view of the functioning of the economy. According to monetarist economics, there is a distinct division between real and monetary variables. Growth is determined only by real variables whilst money only determines the overall price level. Therefore, the goal for monetary policy is to maintain price stability, while any attempt to influence real variables, through changes in money aggregates, would have the only effect of creating inflation. To avoid inflation, according to monetarists, money supply must grow at a pace equal to the growth rate of the economy. Following the quantity theory of money, prices would remain stable. The attainment of price stability is an important pre-requisite of a stable economic


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