Quantitative implications of indexed bonds in small open economies

C. Bora Durdu

No 909, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

Abstract: This paper analyzes the macroeconomic implications of real-indexed bonds, indexed to the terms of trade or GDP, using a general equilibrium model of a small open economy with financial frictions. Although indexed bonds provide a hedge to income fluctuations and can thereby mitigate the effects of financial frictions, they introduce interest rate fluctuations. Because of this tradeoff, there exists a nonmonotonic relation between the \"degree of indexation\" (i.e., the percentage of the shock reflected in the return) and the benefits that these bonds introduce. When the nonindexed bond market is shut down and only indexed bonds are available, indexation strengthens the precautionary savings motive, increases consumption volatility and deepens the impact of Sudden Stops for degrees of indexation higher than a certain threshold. When the nonindexed bond market is retained, nonmonotonic relationship between the degree of indexation and the benefits of indexed bonds still remain. Degrees of indexation higher than a certain threshold lead to more volatile consumption than lower degrees of indexation. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as on the relative openness of the economy.

Keywords: Inflation-indexed bonds; bond markets (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-dge and nep-mac
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Citations: View citations in EconPapers (6)

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Related works:
Journal Article: Quantitative implications of indexed bonds in small open economies (2009)
Working Paper: Quantitative Implications of Indexed Bonds in Small Open Economies (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:909

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