Inflation Expectations, Interest Rates and Arbitrary Income Transfers

Abstract

Unexpected inflation, disinflation or deflation causes arbitrary income transfers between an economy's borrowers and lenders. This redistribution results from distorted real interest rates that are too high when price level changes are over-predicted and too low when under-predicted. This paper shows that in Australia's case, inflation expectations were mostly biased upwards throughout the 1990's, according to the Melbourne Institute series and to a new derived series based on bond yields, implying that real interest rates were too high over this time. In turn, this caused substantial arbitrary income transfers between debtors to creditors, estimated to have averaged up to three percent of GDP over the period.