Money Illusion and TIPS Demand

Abraham Lioui and Andrea Tarelli

Journal of Money, Credit and Banking, 2023, vol. 55, issue 1, 171-214

Abstract: The market demand for the Treasury Inflation‐Protected Securities (TIPS) is rather small. This is puzzling, as we show that an agent, who derives utility from real wealth and dynamically invests into multiple asset classes over a 30‐year horizon, incurs a certainty equivalent loss of 1.6% per annum from not investing in inflation‐indexed bonds. However, if the investor suffers from money illusion, the perceived loss is only 0.5% per annum. Furthermore, the perceived loss is totally negligible for an unsophisticated money‐illusioned investor ignoring the time variation of risk premia. Money illusion causes significant portfolio shifts from inflation‐indexed toward nominal bonds, with little effects on equity allocations, contributing to the low market demand for TIPS.

Date: 2023
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https://doi.org/10.1111/jmcb.12923

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Persistent link: https://EconPapers.repec.org/RePEc:wly:jmoncb:v:55:y:2023:i:1:p:171-214

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