If you were going to issue bonds, would you prefer to be in a country where the average inflation rate is 3% inflation but fluctuates wildly, or in a country with a higher, 4% expected inflation rate that is stable (meaning it's always 4%). Explain.
What will be an ideal response?
Even though the 4% expected rate is higher, it is stable. As we saw, the inflation risk isn't really the risk from inflation; it is the risk that results from unexpected changes in inflation which then can significantly alter the real interest rate, and therefore the real returns bondholders receive. Because bondholders tend to be risk-averse, they would want to be compensated for the inflation risk, and since the inflation risk results from the fluctuations in the rate of inflation, the returns required by bondholders in the country where the average expected rate is 3% but volatile are likely to be higher than the required returns on the bonds in the higher but stable inflation country. This explains, at least partially, why the central banks in many developed countries strive for inflation stability. Stable prices will lead to lower inflation risk and a more efficient bond market.
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