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A Portfolio-Balance Model of Inflation and Yield Curve Determination

Antonio Diez de los Rios ()

Staff Working Papers from Bank of Canada

Abstract: We propose a portfolio-balance model of the yield curve in which inflation is determined through an interest rate rule that satisfies the Taylor principle. Because arbitrageurs care about their real wealth, they only absorb an increase in the supply of nominal bonds if they are compensated with an increase in their real rates of return. At the same time, because the Taylor principle implies that short-term nominal rates are adjusted more than one for one in response to changes in inflation, the real return on nominal bonds depends positively on inflation. In equilibrium, inflation increases when there is an increase in the supply of nominal bonds to compensate arbitrageurs for the additional supply they have to hold.

Keywords: Asset Pricing; Debt Management; Inflation and prices; Interest rates; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E52 G12 H63 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2020-03
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:20-6

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