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Indexed versus nominal government debt under inflation and price-level targeting

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  • Michael, Hatcher

Abstract

This paper presents a DSGE model in which long run inflation risk matters for social welfare. Optimal indexation of long-term government debt is studied under two monetary policy regimes: inflation targeting (IT) and price-level targeting (PT). Under IT, full indexation is optimal because long run inflation risk is substantial due to base-level drift, making indexed bonds a much better store of value than nominal bonds. Under PT, where long run inflation risk is largely eliminated, optimal indexation is substantially lower because nominal bonds become a better store of value relative to indexed bonds. These results are robust to the PT target horizon, imperfect credibility of PT and model calibration, but the assumption that indexation is lagged is crucial. From a policy perspective, a key finding is that accounting for optimal indexation has important welfare implications for comparisons of IT and PT.

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Paper provided by Scottish Institute for Research in Economics (SIRE) in its series SIRE Discussion Papers with number 2013-56.

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Date of creation: 2013
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Handle: RePEc:edn:sirdps:483

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Keywords: government debt; inflation risk; inflation targeting; price-level targeting;

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