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Domestic bond markets and inflation

Andrew Rose () and Mark Spiegel ()

No 2015-5, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: This paper explores the relationship between inflation and the existence of a local, nominal, publicly-traded, long-maturity, domestic-currency bond market. Bond holders are exposed to capital losses through inflation and therefore represent a potential anti-inflationary force; we ask whether their influence is apparent both theoretically and empirically. We develop a simple theoretical model with heterogeneous agents where the issuance of such bonds leads to political pressure on the government to choose a lower inflation rate. We then check this prediction empirically using a panel of data, examining inflation before and after the introduction of a domestic bond market. Inflation-targeting countries with a bond market experience inflation approximately three to four percentage points lower than those without one. This effect is economically and statistically significant; it is also insensitive to a variety of estimation strategies, including using political and fiscal variables suggested by theory to account for the potential endogeneity of domestic bond issuance. Notably, we do not find a similar effect for short-term or foreign-currency bonds.

Keywords: empirical; panel; long; maturity; domestic; currency; risk; fixed; effect; nominal; debt (search for similar items in EconPapers)
JEL-codes: E52 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac, nep-mfd and nep-mon
Date: 2015-02-17
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfwp:2015-05

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DOI: 10.24148/wp2015-05

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Handle: RePEc:fip:fedfwp:2015-05